Why Should You Care about Inflation?
What are the effects of inflation?
Inflation affects everyone in the economy, and it often imposes some costs, although it can also provide some benefits. High rates of inflation as well as deflation are problematic for an economy. The more harmful effects of inflation, however, stem from its unpredictability—that is, the fact that movements in inflation from period to period cannot be perfectly anticipated.
What problems does predictable inflation cause?
Even if everyone could predict what inflation was going to be, there are still ways in which rising prices would impose costs on an economy.
Businesses have to update materials in which their prices appear (think of a restaurant that needs to print new menus, or retailers that must print new catalogs or update price tags). At higher inflation rates, these businesses would need to expend more resources to change prices more frequently, or else their prices may be further from their desired level after accounting for the movements of competitors' prices.
Those on fixed incomes lose
For people whose pensions or incomes are fixed in nominal terms, rising prices reduce the real purchasing power of those incomes and pensions.
There are also costs associated with tax laws, which generally do not take into account the effects of inflation, especially when calculating capital gains. Even if workers receive wage increases to match inflation, higher wages can raise tax liabilities and result in their after-tax incomes' not keeping up with higher prices.
Because higher inflation leads to higher interest rates, people will generally want to economize on the amount of cash that they carry in order to leave more of it in the bank where it can earn interest. Consequently, people will incur the cost of more trips to the bank.
What problems does unpredictable inflation cause?
Borrowers and lenders
Interest rates specified in loan agreements typically incorporate a component based on the expected rate of inflation over the length of the loan. If inflation turns out to be higher than expected, then the debtor benefits because the repayment (adjusted for inflation) turns out to be lower than what the two parties anticipated. If inflation turns out to be lower than expected, then the creditor benefits because the inflation-adjusted repayment will be higher than what was anticipated by both parties. Consequently, unanticipated inflation transfers wealth across borrowers and lenders arbitrarily.
Savings and investment decisions
When inflation becomes less predictable, then both consumers and firms will face greater uncertainty. Because the decisions of consumers and firms depend on their view of future conditions, greater uncertainty can cause them to alter their plans. For example, higher uncertainty about future inflation will also extend to greater uncertainty about interest rates, wages, taxes, and profits. In response, businesses may delay or postpone hiring decisions and expenditures on new buildings and equipment, while households may cut back on consumption and save more. Both of these types of responses can lead to reduced spending and lower activity in an economy.
Relative price changes
When the price of an item increases, it is important to know how the size of that price change compares to the sizes of other price changes. For example, when the price of an item increases more than the prices of other items, its relative price increases, and consumers will substitute toward relatively cheaper items. If the price change matches those of other items, then the item's relative price has not changed and would not induce a substitution. The more unpredictable inflation is, the harder it is for consumers to determine the relative price change of items and the harder it becomes for them to spend their income efficiently.
The inflation outlook
When inflation becomes less predictable, consumers and businesses spend more time, attention, and income trying to monitor and forecast inflation, as well as making plans and taking actions to protect themselves from its effects.
Want to keep reading? Learn why the Fed cares about inflation