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Consequences of Inflation

Consequences of Inflation

Do you have an item that you purchase every week, no matter the circumstances? Whether it's something as small as a cup of coffee, or as large as an entire grocery list, there are some expenses that we all make regularly. You may have even memorized the price of these goods from frequent purchasing!

But what if the prices shot up one day and you were unable to purchase those items — what would you do? Forgo buying the goods you've come to buy regularly? Buy the goods at a higher price? This is an issue that can plague economies all around the world — inflation. Continue reading to learn more about how inflation affects the economy, government, and people!

Consequences of inflation on the economy

To understand the consequences of inflation on the economy, we first must understand what is meant by inflation and economy, respectively. Inflation is the general increase in prices. The Economy is about managing the resources available to a country. Now that we have our foundation, we can begin to answer the question: how does a general increase in prices affect the management of resources?

If prices increase without a proportionate increase in income, reduced purchasing power will occur. This means that the value of the dollar is falling and unable to purchase the same number of goods as it once was able to. If the dollar is purchasing fewer goods than it once was, spending patterns will also change. What was once a cyclical purchase for an individual may have to be cut out of their budget due to increased prices.

These effects can make an economy, or the managing of resources, unstable. The production and consumption of goods will become discordant, resulting in resources becoming scarce or overabundant.

Inflation is the increase in prices.

The Economy is about managing the resources available to a country.

Consequences of Inflation, Dollar Burning symbolizing Consequences of Inflation on the Economy, StudySmarterA Dollar Burning, pixabay

Consequences of inflation on the government

Let's go over the consequences of inflation on the government. A government will not be hurt by a small amount of inflation; in fact, central banks aim for around 2% inflation each year. This can be a sign of a growing economy! But uncontrolled and rapidly increasing inflation is dangerous for a government — this is known as hyperinflation.

A government will be heavily impacted by hyperinflation. For example:

Say the United States is going through hyperinflation. The United States will lose trust in its financial institutions from other governments if hyperinflation occurs. If other governments lose trust in the United States' financial institutions, who will engage in free-market trade with them? Who will trade currencies with the failing U.S. dollar in the foreign exchange market? No one! It is too large of a risk for other governments if the United States is going through hyperinflation.

Hyperinflation alone can break down a government, but losing the financial trust of other governments will worsen the situation.

Hungary's Hyperinflation

During World War II, Hungary went through immense hyperinflation. The hyperinflation was so great that it currently holds the record as the highest inflation rate ever.1 A large amount of currency printing was done to abate the high wartime government debt. Post World War II, 828 octillion pengös was equal to 1 pengö pre-World War II.

(828 octillion = 828,000,000,000,000,000,000,000,000,000)

Hyperinflation is rapidly increasing prices.

Consequences of inflation for consumers

Let's go over the consequences of inflation on consumers. Increasing prices can have positive or negative effects depending on a few factors. A consumer's income level and whether they are borrowing or lending money will determine if inflation is affecting consumers positively or negatively. Let's go over both factors to see their effects.

Consequences of inflation for consumers: level of income

If a consumer has a low level of income, how might inflation affect them? Increasing prices will be exceptionally hard to deal with if a consumer has a low level of income. If prices continue to increase as incomes stay the same, consumers will not be able to purchase the same number of goods that they once were able to. Consumers' grocery lists, living situations, and bills will be compromised. This is a result of increasing prices outpacing consumers' low-income levels — reduced purchasing power.

If a consumer has a high level of income, how might inflation affect them? Increasing prices are still going to negatively impact high-income earning consumers, but not as severely as low-income earning consumers. High-income earning consumers can "absorb" the increasing prices because of their higher incomes. They will still pay more overall due to increasing prices, but they will not be hurt as much as low-income earning consumers. Their purchasing power is also reduced, but it is not as deleterious as it would be for low-income earning consumers.

Consequences of inflation for consumers: borrowers vs lenders

If a consumer is borrowing or lending money, are they both affected in the same way by inflation? No. In fact, one benefits while the other loses. A borrower will benefit from inflation since inflation devalues the dollar overall, resulting in less money owed to the lender. Let's look at a quick example.

Let's say you borrow $50 from your best friend to buy a video game, and suddenly inflation hits. That $50 you borrowed is worth less now than before inflation hit due to reduced purchasing power. $50 will no longer buy you a video game after inflation. Therefore, without interest, you still only owe $50 at a new devalued rate. You benefit from inflation!

Originally $50 was equal in value to a video game, however, after inflation, it is worth less than a video game. So when you pay it back, you are paying back less value according to its purchasing power even though it's the same $50.A lender will be hurt by inflation since the money they are paid back will be lower in value. Let's look at a quick example.

Let's say you lend your friend $1000 to help him with his rent, and suddenly inflation hits. The $1000 you lent your friend is worth less now than before inflation hit due to reduced purchasing power. When you are paid back the $1000, you will not be able to purchase the same number of goods as a result of inflation. Since the $1000 you are paid back buys you fewer goods, you lose from inflation!

Consequences of Inflation, U.S. Consumer Price Index for the Month of May showing the Consequences of Inflation for Producers, StudySmarterFigure 1. U.S. Consumer Price Index for the month of May, StudySmarter Originals. Source: U.S. Bureau of Labor Statistics2

The figure above shows the consumer price index for the month of May. As you can see, the price for consumer goods shot up tremendously in 2022! Consumers will definitely be affected as a result of this inflation. How they get impacted is heavily contingent on income level.

Consequences of inflation for producers

Let's go over the consequences of inflation for producers. It all links back to consumer behavior. If consumers are not buying as many goods as they once were due to increasing prices, how might that affect producers?

The negative effects of inflation for producers come from the decisions they have to make: increase or decrease prices due to inflation. Producers have two options: sell to those who can afford the goods at a higher price, or lower their prices to make their products cheaper. What are the results of both decisions?

If producers sell their goods only to higher-income consumers, then they miss out on many consumers who can't purchase their products due to inflation. However, producers may increase their profits if they increase their prices — it's a risky decision either way.

If producers lower their prices to make their products cheaper, producers risk shortages of goods since their products are relatively cheaper than other products on the market. Producers acting altruistically risk lowering their profits as a result of decreasing prices.

Consequences of deflation

Before going over the consequences of deflation, let's define deflation: the decrease in the price of goods. You may think that a decrease in the price of goods is a great thing! Maybe now you can buy a car or afford a mortgage. This does sound great, but what are the larger impacts of the price of goods falling?

Let's say you want to buy a new laptop and you know the price will go down next month. Will you buy it now or later? Probably later to save money. This concept also applies to deflation — a decrease in the price of goods will make people hold off on purchasing items. This can be bad for an economy since there's minimal activity in the market. Consumers are not buying, producers are not making, and the whole economy becomes stagnant. To keep an economy growing, a small amount of inflation is desired!

Deflation is the decrease in the price of goods.


Consequences of Inflation - Key takeaways

  • Inflation is an increase in the price of goods.
  • Deflation is a decrease in the price of goods.
  • The economy becomes unstable when inflation occurs.
  • Inflation will affect consumers differently depending on income level.
  • Inflation will affect producers differently depending on whether producers increase or decrease prices during inflation.

References

  1. William A. Bomberger, The Hungarian Hyperinflation and Stabilization of 1945-1946, https://www.jstor.org/stable/1837370
  2. U.S. Bureau of Labor Statistics, CPI for all Urban Consumers, https://data.bls.gov/pdq/SurveyOutputServlet Federal Reserve, Federal Reserve Issues FOMC

Frequently Asked Questions about Consequences of Inflation

The negative effects of inflation are reduced purchasing power and changing spending/producing patterns, resulting in an unstable economy. The positive effects of inflation is that those that borrow money before inflation will benefit once inflation takes place.

A small amount of inflation is good for the government. Large amounts of inflation is known as hyperinflation and is bad for the government.

The consequences are reduced purchasing power affecting the purchases of goods.

Inflation can benefit producers if they increase their prices and people are still buying them.

Inflation is caused by an increase in prices; deflation is caused by a decrease in prices. The consequences of inflation are a change in consumer spending and reduced purchasing power; the consequence of deflation is economic stagnation.

Final Consequences of Inflation Quiz

Question

What is inflation?

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Answer

An increase in prices

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Question

What is deflation?

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Answer

A decrease in the price of goods

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Question

What is the economy?

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Answer

The management of resources available to a country

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Question

Why is inflation bad for an economy?

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Answer

Increased difficulty of managing resources

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Question

What is hyperinflation?

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Answer

Rapidly increasing price of goods

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Question

How is deflation bad for an economy?

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Answer

Falling prices encourage people to wait to purchase goods at a later date

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Question

How are borrowers affected by inflation?

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Answer

Borrowers benefit from inflation

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Question

How are lenders affected by inflation?

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Answer

Lenders are hurt by inflation

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Question

True or False: Inflation reduces purchasing power.

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Answer

True

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Question

How much does a central bank target for inflation?

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Answer

2%

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Question

True or False: both low-income and high-income earners are affected by inflation.

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Answer

True

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Question

You borrow $100 from your friend that you have to pay back next year. However, inflation surpasses expectations! Who benefits from inflation?

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Answer

You

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Question

You lend $500 to your friend with the deal that you get paid back next year. However, inflation hits! 

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Answer

Your friend

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Question

True or False: Producers only suffer negative consequences with inflation

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Answer

False

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Question

Which country has the highest recorded inflation rate in history?

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Answer

Hungary

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