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Costs of Inflation

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Costs of Inflation

Is inflation good or evil? What are the costs of inflation in the first place and are there any benefits? While there are definitely negative aspects to it – like your money being worth less and less every day – there are some positive parts to it as well. Inflation is not beneficial for everyone and certain groups are affected more than others by it. In this article we'll be going into detail regarding the different types of inflation, what causes it, the effects, and some strategies the government used to combat it. Ready? Set! GO!

Cost of Inflation Definition

Inflation occurs when goods and services become more expensive over time. With it, your purchasing power weakens and that means in the future your dollar will be worth less and can buy less. Inflation can harm individuals by reducing the value of their money (particularly savings) and shifting the distribution of income to lenders and asset-holders. If inflation rises to levels that are too high, it can damage the economy.

Inflation occurs when the general price level in the economy increases over time.

The cost of inflation is any negative consequences for the economy resulting directly or indirectly from inflation.

Cost of Inflation Causes

While there are multiple types of inflation, we usually categorize them into two main ones. These are demand-pull inflation and cost-push inflation.

Demand-pull Inflation: Cost of Inflation Causes

This type of inflation is triggered when aggregate demand increases. This increase in demand comes from businesses, governments, households, and even foreign buyers. If that demand exceeds supply, all of the four sections compete for the limited supply. As they keep bidding to get the goods/services they want, they, in turn, keep increasing the price of the goods/services in the whole economy and this causes inflation. This is known as a lot of money "chasing too few goods".

Aggregate demand is a measure of overall demand for goods/services throughout all sectors of the economy.

Let's take a look at the diagram below:

Costs of Inflation Demand-pull inflation StudySmarter OriginalsFigure 1. Demand-pull inflation, StudySmarter Originals

Figure 1 above shows demand-pull inflation. The aggregate price level in the economy is shown on the vertical axis, while real output as measured by real GDP is on the horizontal axis. Long-run aggregate supply curve (LRAS) represents the full employment level of output that the economy can produce labelled by YF. The initial equilibrium, labelled by E1 is at the intersection of the aggregate demand curve AD1 and short-run aggregate supply curve SRAS. Initial output level is Y1 with the price level in the economy at P1. A positive demand shock causes aggregate demand curve to shift to the right from AD1 to AD2. The equilibrium after the shift is labelled by E2, which is located at the intersection of the aggregate demand curve AD2 and short-run aggregate supply curve SRAS. The resulting output level is Y2 with the price level in the economy at P2. The new equilibrium is characterized by higher inflation due to an increase in aggregate demand.

Cost-push Inflation: Cost of Inflation Causes

Cost-push inflation occurs when there's a decrease in the aggregate supply of goods/services due to rising costs of production. Basically, this means that prices have gotten higher because the prices of production have also gotten higher. Included in this is land, labor, and capital. Companies aren't able to keep producing the same amount of goods/services at the same price because it has gotten more expensive to produce those goods/services. To make a profit, they are going to increase prices which creates inflation.

Aggregate supply is the economy's total production of goods/services throughout all sectors of the economy.

Let's see what cost-push inflation looks like graphed out:

Costs of Inflation Cost-push inflation StudySmarter OriginalsFigure 2. Cost-push inflation, StudySmarter Originals

Figure 2 above shows cost-push inflation. The aggregate price level in the economy is shown on the vertical axis, whilst real output as measured by real GDP is on the horizontal axis. Long-run aggregate supply curve (LRAS) represents the full employment level of output that the economy can produce labelled by YF. The initial equilibrium, labelled by E1 is at the intersection of the aggregate demand curve AD and short-run aggregate supply curve – SRAS1. Initial output level is Y1 with the price level in the economy at P1. A negative supply shock causes aggregate supply curve to shift to the left from SRAS1 to SRAS2. The equilibrium after the shift is labelled by E2, which is located at the intersection of the aggregate demand curve AD and short-run aggregate supply curve – SRAS2. The resulting output level is Y2 with the price level in the economy at P2. The new equilibrium is characterized by higher inflation due to a decrease in aggregate supply.

Extreme Types of Inflation: Positive and Negative Effects of Inflation

Despite the fact that we consumers dislike rising prices, economists think that as long as inflation stays at a decent level it's actually beneficial to the health of the economy. The issue comes in when we have inflation that exceeds a tolerable amount. Let's learn about the three types of inflation that are of most concern to economists.

To learn more about why inflation staying within a decent level is actually beneficial, check out our explanation on Moderate Inflation

Cost of Inflation: Hyperinflation

When prices begin to rise over the accepted level, this brings the fear of hyperinflation. This type is a rapid and uncontrollable increase in inflation. Due to rising prices consumers, as well as businesses, have to spend more money to buy the products they want/need. The money they do have is losing value every time the hyperinflation rate gets higher and puts people at risk of bankruptcy.

Learn more about Hyperinflation in our explanation.

Cost of Inflation: Stagflation

Stagflation occurs when the inflation rate and unemployment are high and rising, whilst the economy's output is falling.

But why is this such a bad thing?

Normally, it's expected that unemployment will go up when the economy slows down. However, the fact that prices are rising at the same time as unemployment is cause for concern. In a low-employment environment, consumers have less spending power. If you add high inflation rates to that, then people's money becomes less valuable with each passing day. Essentially, money has less value and there's less of it available to spend.

To learn more about the effects of the money supply on inflation check our explanation - Money Growth and Inflation

Cost of Inflation: Deflation

Deflation, or negative inflation, is characterized by dropping prices. It is different from disinflation when the rate of inflation falls but still remains positive – the prices are rising but at a slower rate. If the supply of money decreases, the value of it increases. Both of these together mean that prices will also decrease. A drop in demand could also cause prices to fall. At first, deflation sounds like a good thing! Prices of things are getting lower so why should we be concerned?

Let's break this down.

If prices drop that means that businesses had to lower their prices. Which means that they're making less money. Since they're losing out on making a profit, they have to save money some other way. They do this by laying off or firing the employees that work for them, and by doing so, they increase the rate of unemployment.

To learn more about disinflation see our explanation on - Disinflation

Causes of Inflation

Several things can cause a spike in inflation. The main ones are:

  • A rise in production costs
  • A rise in demand for products/services
  • High supply of available money compared to the size of the economy
  • Supply shocks

A supply shock occurs when surprising situations arise that interrupt production, natural disasters for example, or situations that make production costs more expensive, like an increase in wage costs.

Consequences of Inflation

While it's easy to imagine that inflation only has negative consequences, we have to remember that there are two sides to every coin. There are a few positive consequences of inflation as well as negative.

Cost of Inflation Examples: Negative Effects of Inflation

Let's take a look at the negative effects of inflation.

Cost of Inflation: Value of money decreases

Simply put, money loses its value as prices increase.

Cost of Inflation: Inequality

Most of the burden of inflation falls on low-income households. Since they spend the highest percentage of their income on necessities, inflation typically consumes a larger proportion of their income. Asset prices (like housing and stocks) also tend to rise when inflation is present. The increase in these prices overtakes the rising inflation rates. Since richer households tend to have more assets, it increases the amount of inequality even more. How so? It's due to the fact that the assets go up in value quicker than ordinary goods such as groceries. As a result, they find themselves with more money than before while the low-income families are forced to spend more money just to survive.

Cost of Inflation: Cost of living goes up

As prices begin to rise, consumers will of course have to pay more for both necessary things and luxuries. If incomes increase alongside inflation, then this might not be problematic. But in the case that incomes do not change alongside inflation, then there will be more issues. The percentage of income spent on the same amount of goods will rise. Additionally, inflation shifts workers into higher tax brackets which means their taxes will go up. If inflation isn't taken into account when calculating the tax brackets, workers will end up in a worse situation than before.

Cost of Inflation Examples: Positive Effects of Inflation

There are positive effects of inflation, just like there are negative! Let's take a look at what they are by looking at some cost of inflation examples.

Cost of Inflation: Rise in investments

The rise in inflation motivates people to spend now rather than wait until later when their money might be worth less. For some, this might look like a lot of large purchases such as cars and electronics. For others, this might make them want to seek the greatest return on investment. Since money is worth less when inflation occurs, consumers want to stay above inflation as much as possible so they can keep their purchasing power at the same level. The way they try to do this is to seek high-yielding investments. This is a great move for the economy because money is being moved to parts of the economy that are extremely productive.

Cost of Inflation: Reduce debt

If a person has a large amount of debt, they might actually reap some reward from an increase in the rate of inflation. Suppose you have a loan out with the bank. Your interest rate is at 3%. If the inflation rate rises to 15% and your income rises alongside it, then the rate at which you're paying the bank back actually declines!

Economic Costs of Inflation

The most common inflationary costs are shoe leather costs, menu costs, loss of purchasing power, and wealth redistribution:

Costs: Shoe Leather

The shoe leather cost is the cost of time consumed and effort spent by people attempting to offset the consequences of inflation, such as saving less cash, dealing in foreign currencies with lower rates of inflation, and making more visits to the bank. The name stems from the fact that more walking is necessary to travel to the bank, collect money, and spend it, causing shoes to wear out faster. A lot of time and relaxation is the price that has to be paid for lowering money holdings.

Costs: Menu Costs

A menu cost is the expense incurred by a business as a result of altering its prices. The term derives from the expense of restaurants printing new menus, but now it's used to refer to the costs of altering pricing in general. With high inflation, businesses must alter their pricing often frequently in order to keep up with broader economic developments, and this sometimes proves to be an expensive activity: directly, such as printing new menus, and indirectly, such as the extra time spent and effort required to change prices on a regular basis.

Costs: Loss of Purchasing Power

Inflation, by nature, reduces the purchasing power of a single dollar over time. With inflation, each dollar has less purchasing power. As a result, those with the same pay next year as they do this year will be able to buy less. Purchasing power could be sustained if salaries rise at the same pace as inflation, although this is not always the case. People lose buying power when salaries rise at a slower rate than inflation.

Costs: Wealth Redistribution

Inflation's influence is not dispersed equally across the economy, and as a result, there are hidden costs for some and advantages for others from this fall in money's purchasing power. For instance, when the price of hard assets (such as real estate or stocks) rises due to inflation, those who own them gain, but those who want to buy them must pay a higher price.

Main parties Involved and their Roles in Costs of Inflation

Everyone plays a part in inflation, but the extent to which they're involved varies. We'll discuss the main people involved and if they benefit from inflation or not.

Cost of Inflation: Consumers

Consumers tend to have little benefit from inflation, especially if their pay does not increase when the rate of inflation does. They suffer from the higher prices of goods/services while still having the same amount of money.

Cost of Inflation: Investors

Investors actually tend to benefit a bit if their stocks are in the sectors hit by inflation. For example, if you're an investor and you have stocks in the gasoline sector, then you might notice an increase in your stock prices due to the gas prices going up.

How We Deal with Costs of Inflation

The government will usually step in to help fight the negative consequences of inflation once it starts to become concerning. A few of the ways are:

  • Controlling wages and prices.
  • Reducing the supply of money.
  • Increasing interest rates to deter borrowing.

To learn more about the policies that the government implements that can help tackle inflation, dive into our explanations – Fiscal Policy and Monetary Policy.

Costs of Inflation - Key takeaways

  • Inflation is when goods and services become more expensive over time.
  • Demand-pull and cost-push are the two main types of inflation.
  • Hyperinflation, deflation, and stagflation are extreme types of inflation.
  • A supply shock is when surprising situations arise that interrupt production, natural disasters for example, or situations that make production costs more expensive, like an increase in wage costs.
  • Negative consequences of inflation are decreasing value of money, inequality, and the cost of living going up.
  • Positive consequences of inflation include a rise in investments and reduced debt.
  • The government tries to control inflation by controlling wages/prices, reducing the amount of money available, and increasing interest rates.

Frequently Asked Questions about Costs of Inflation

The costs of inflation are any negative consequences for the economy resulting directly or indirectly from inflation.

Inflation increases the cost of living as prices rise.

Inflation increases the cost of capital as prices rise.

Inflation is not the same as the cost of living. Cost of living refers to the overall cost of the basket of goods that a typical household purchases. Inflation refers to the rate of change in the prices of that basket of goods.

Cost of inflation index is the CPI which measures a general increase in the overall prices in the economy

Final Costs of Inflation Quiz

Question

What is inflation?

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Answer

Inflation occurs when goods and services become more expensive over time.

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Question

What are the two main types of inflation?

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Answer

The two main types are demand-pull and cost-push. 

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What's aggregate demand?

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Answer

Aggregate demand is a measure of overall demand for goods/services throughout all sectors of the economy.

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What's aggregate supply?

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Answer

Aggregate supply is the economy's total production of goods/services at a particular price level.

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What are the three extreme types of inflation?

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Answer

Hyperinflation, stagflation, and deflation are the extreme types. 

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What's the other name for deflation?

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Answer

Deflation is also known as negative inflation! It's the opposite of inflation in the sense that instead of prices increasing, prices begin to drop.

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What are the causes of inflation?

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  • A rise in production costs
  • A rise in demand for products/services
  • High supply of available money compared to the size of the economy
  • Supply shocks

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Define supply shock.

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Answer

A supply shock is when surprising situations arise that interrupt production, natural disasters for example, or situations that make production costs more expensive, like an increase in wage costs. 

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Question

Name the three negative consequences of inflation.

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Answer

The value of $ decreases, inequality increases, and cost of living increases as well. 

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Name the two positive consequences of inflation. 

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Answer

There tends to be a rise in investments, and debt gets reduced. 

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Do consumers benefit from inflation?

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No. Consumers actually tend to benefit the least from inflation. Especially if their wages remain the same while the inflation rate is increasing. 

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List the three main ways the US government tends to try to control inflation?

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  • Controlling wages and prices
  • Reducing the supply of money 
  • Increasing interest rates to deter borrowing

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When do economists believe that inflation is beneficial? 

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Answer

When inflation remains within an acceptable range, it's healthy for the economy. But when the inflation rate starts rising out of control, the economy becomes damaged. 

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What's the difference between hyperinflation and deflation?


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With hyperinflation, the rate of inflation grows rapidly and uncontrollably. This causes prices to go up as well. 


With deflation, prices actually drop to such a low point that businesses have to cut costs to make profits and they do so by laying off or firing their workers. So prices are low but unemployment is higher. 

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Why do investors tend to benefit from inflation?

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If investors hold stocks in parts of the market that are affected by inflation, then the cost of their stock will go up. They can choose to sell these at these high prices and make a profit. 

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Question

Any negative consequences for the economy resulting directly or indirectly from inflation is known as

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cost of inflation

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Demand-pull inflation is triggered when...

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aggregate demand increases

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When too much money is chasing too little goods, what can occur?

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demand-pull inflation

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When does cost-push inflation occur?

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decreasing aggregate supply

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Which of the following is NOT an extreme type of inflation?

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None of the above

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Which of the following can cause a supply shock?

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All of the above

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Which of the following is NOT a cost of inflation?

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Rise in investment

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Which of the following are positive effects of inflation?

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Rise in investment

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True or False: There is NO benefits to inflation.

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False

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True or False: inflation affects lower-income people more than higher-income people.

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True

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True or False: Deflation is when prices increase slowly.

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False

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True or False: the government cannot control inflation.

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False

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True or False: increasing interest rates can mitigate inflation


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True

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What can the government do to control inflation?

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Decrease government spending and increase taxes

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What can the fed do to control inflation?

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Reducing money supply and raising interest rates

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How do investors benefit from inflation?

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If investors have stocks in sectors where prices are increasing, they will see higher return on investments

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How do consumers lose from inflation?

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If wages don't increase, they cannot afford as many products anymore

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What is it called when businesses raise prices as a result of inflation?

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Menu costs

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