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Inflation Explained: Your Guide to Inflation Basics

Why Should You Care about Inflation?

What would you do if the money in your wallet or bank account could buy less and less every year? Would you spend more time thinking about how to get the most out of your money while you could? Would you change what you bought or how much? Would you keep money in your savings account?

What are the effects of inflation?

Inflation affects everyone in the economy: workers, businesses, people on fixed incomes, lenders, and borrowers. For example, consumers tend to keep track of the prices of items they purchase. When inflation is high, they may spend more time shopping, looking for the best deals. Companies often think about how much to raise prices as it becomes costlier to produce their products. Individuals may also act to protect their financial assets from rising prices.

Inflation can also be very hard for people on fixed incomes. Inflation means their incomes won't stretch as far as they could before, and people will have to buy less. If inflation is moderate (prices are increasing by a little), they may have to cut back on non-necessities such as leisure travel, movies, or eating out. If inflation is high, they might have to cut back on necessities such as utilities and food.

Another problem caused by inflation is that it is unpredictable. That is, we cannot perfectly know what inflation is going to be in the future. Interest rates reflect, in part, what inflation is expected to be over the life of a loan. Inflation that is higher or lower than expected can create "winners" and "losers" because it shifts purchasing power between savers and borrowers. If inflation is higher than expected, borrowers (debtors) win because they repay the loan with less-valuable dollars. However, if inflation is lower than expected, savers (creditors) win because the loan repayment is worth more as it reflects more-valuable dollars.

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 expected 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.

Menu costs

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 may 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.

Tax implications

There may also be costs associated with tax laws, which generally do not take into account the effects of inflation. 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.

Shoe-leather costs

Because higher inflation often 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 unexpected inflation cause?

Inflation effects on 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.

Inflation effects on 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, greater 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 types of responses can lead to reduced spending and lower activity in an economy.

Inflation effects on 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.

Inflation effects on the inflation outlook

When inflation becomes less predictable, consumers and businesses spend more time, attention, and income trying to monitor and forecast inflation and taking actions to protect themselves from its effects.

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