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Effects of Inflation

Effects of Inflation

Imagine you lend 1,000 dollars to your friend and agree that your friend will return your money the following year with zero interest. However, a supply shock causes the price of all goods in grocery stores to increase by 50%, which means that your $1,000 would be half of the goods you could buy when you lent the money to your friend. This is how inflation affects your money. How about the economy? What are some of the effects of inflation on the economy? Is inflation always bad? Read on to learn all there is about the effects of inflation and how to negotiate better deals when lending money to your friend next time.

Effects of Demand-Pull Inflation

Demand-pull inflation has many effects, such as reducing consumer purchasing power, increasing borrowing costs, and continuing inflation growth.

Rises in the general price level occur when the total production capacity of the economy is incapable of meeting the increase in demand for goods and services.

Demand-pull inflation occurs when aggregate demand in the economy is higher than aggregate supply.

Figure 1 shows some of the main effects of demand-pull inflation, including increased cost of living, drop in purchasing power, higher cost of borrowing, and lower unemployment.

When an economy is experiencing demand-pull inflation, there is an excessive money supply flooding the markets; however, there are limited goods and services available in the economy. When customer demand for various consumer items exceeds the available supply, demand-pull inflation begins to take effect. This results in an overall increase in the cost of living for consumers.

Effects of Inflation Demand-pull inflation StudySmarterFig. 2 - Demand-pull inflation

Figure 2 shows the demand-pull inflation using the AD-AS model. As the overall consumption in the economy increases, it causes the aggregate demand curve to shift from AD1 to AD2. The shift in the aggregate demand causes the price level to increase from P1 to P2 and the overall output produced (from Y1 to Y2).

When inflation is high and stays high for an extended period of time, the culprit is generally an excessive amount of money issued by the central bank (the Federal Reserve in the United States). At some point, the Federal Reserve will have to raise the interest rate in the economy to cool down the increase in aggregate demand.

The effect of the rise in the interest rate contributes to the higher cost of borrowing. This would leave individual consumers reducing their consumption and increasing their savings.

Also, in an environment characterized by demand-pull inflation, many consumers experience a reduction in their purchasing power. The supply of goods and services is limited, which bids up the price. The increase in price lowers the number of goods and services one can buy.

Imagine the price of all cars in the economy increased by 20% while the supply of new cars remained relatively steady. In such a case, one would lose 20% of their purchasing power when it comes to buying cars.

Another effect of demand-pull inflation is that the unemployment rate drops. Because of the rapid increase in demand, businesses are expanding their workforce to meet the rising demand for their products. When companies hire additional workers, the number of individuals with jobs grows. That's because businesses increase their capacity to produce by hiring more people to meet the demand increase.

Effect of Cost-Push Inflation

There are many effects of cost-push inflation. Disruption in the supply of goods and services also causes inflation in the economy. This type of inflation is known as cost-push inflation.

Figure 3 shows some of the main effects of cost-push inflation, including a decline in production, higher unemployment, and lower profits.

A well-known example of cost-push inflation is what the United States economy experienced during the 1970s when the general price level rose even if the overall expenditure was not very high.

The effects of cost-push inflation during these times were associated with a decline in production and a rise in unemployment. As production dropped and more people were unemployed, there was less income; hence, the spending in the economy plunged.

Cost-push inflation takes place when the cost of production in the economy rises.

Increasing prices may be broken down into the components that contribute to increased per-unit production costs at any given level of expenditure.

The average cost of producing a certain quantity of goods or services is referred to as the per-unit production cost.

This cost considers all the expenses a business incurs when producing a product.

Effects of Inflation Cost-push inflation StudySmarterFig. 4 - Cost-push inflation

Figure 4 illustrates the cost-push inflation using the AD-AS model. As the cost of raw materials increases, the short-run aggregate supply curve will shift from SRAS1 to SRAS2, changing the equilibrium from E1 to E2. As a result of this shift, the overall prices in the economy increase from P1 to P2, and the output produced drops from Y1 to Y2.

In a cost-push inflation setting, many companies experience their profit drop due to the rise in per-unit manufacturing costs. As a result of the shrink in profits and higher cost of producing, companies lower their output produced.

As a direct consequence of this, the number of products and services available in the economy will fall, leading to an increase in overall prices.

Supply shocks have been the primary contributor to cost-push inflation during the last several decades. In particular, unexpected jumps in the pricing of inputs, such as raw materials or energy, led to a rise in both the overall costs of production per unit and the prices of finished goods.

A classic example of this is the rise in the price of imported oil in 1973–1974 and then again in 1979–1980. During these times, the cost of manufacturing and transporting almost every product in the economy increased, directly resulting from the sharp rise in the price of energy. The result was cost-push inflation.

We have an entire article dedicated to the 'Oil Crisis of 1973'. Feel free to check it out!

In the 'Causes of Inflation' article, we covered the leading causes of all types of inflation. Don't miss out!

Effects of Inflation on the Economy

The effect of inflation on the economy depends on the types of inflation the economy is experiencing. There are different effects when an economy is going through cost-push inflation, and other effects take place when the economy is going through demand-pull inflation.

To understand the effects of inflation on the economy, economists look at whether there is economic growth or more output produced in the economy.

It is crucial to remember that sudden and unanticipated increases in the cost of essential resources like oil may significantly push up total production costs, leading to cost-push inflation.

Individuals cut down on their consumption when there is an increase in the price of the goods and services they consume. As a result of the decrease in demand, businesses respond by reducing their overall production. As less production takes place, fewer workers are needed, which contributes to an increase in the unemployment rate.

During cost-push inflation, there is higher unemployment and less output produced in the economy.

During times of demand-pull inflation, robust levels of total expenditure are needed for full employment and economic development. As more money is in the economy and people are demanding products, more output will be produced. These kinds of expenditures result in large earnings, robust demand for labor, and an excellent incentive for businesses to increase the size of their facilities and the quantity of their machinery.

However, some economists believe that inflation reduces output as individuals dedicate more time to activities that will enable them to hedge against inflation. People will have to spend more time learning about the change in interest rates, prices, and wages. Businesses will also have to spend a considerable amount of time and money adjusting their prices. The productive time gets lost as this time does not contribute to increasing economic output.

Effects of Inflation on Bank's Profitability

Banks work by lending money to individuals in need and charging them a certain amount for the time they used the bank's money, known as the interest rate. As such, inflation's effects on bank profitability are strongly related to whether or not the inflation rate is higher than the interest they charge on a loan.

Real return is the difference between the nominal interest rate and inflation.

The real return one gets on an asset depends on whether or not the interest (return) on that asset is higher than the current rise in price (inflation).

Assume that you lend 10,000 dollars to your friend and agree that they will return 10,500$ next year, which is a 5% return on your loan. However, inflation in the economy is 10%, which means that the prices of all goods and services in the economy increased by 10%. This means that you need $11,000 to buy the same amount of goods and services the following year. This means you lose $500 ($11,000-$10,500), or 5% of your real worth, from lending money to your friend.

The same scenario applies to banks' profitability when the economy is going through inflation. As a result of inflation, the money loses value, but the bank has already agreed to lend a certain amount. Therefore, the money the bank gets after inflation is lower in value when compared to the money it lent. As a result, inflation lowers the bank's profitability.

Effects of Inflation on Consumers

The effects of inflation on consumers depend on whether the individual is a fixed-income receiver, saver, flexible-income receiver, or borrower.

  • Fixed-income receiver. When inflation occurs, those whose earnings are predetermined see a decline in the purchasing power of their dollars. Landlords who receive lease payments in the form of set dollar amounts may experience financial hardship due to inflation since the dollars they receive will have a decreasing value over time. Workers in the public sector, whose earnings are determined by set pay schedules, are susceptible to experiencing the adverse effects of inflation.
  • Savers. Savers are negatively impacted during times of inflation. The actual worth of an accumulation of savings, also known as its buying power, decreases due to rising prices. The real value of paper assets like savings accounts, insurance policies, and annuities declines. This is because inflation eats away at the purchasing power of these assets over time. However, this doesn't apply when the return on savings is higher than the inflation rate.
  • Flexible-Income Receivers. People with flexible incomes may be able to avoid the harmful effects of inflation or may even gain from it. Individuals whose income is linked to the Consumer Price Index have their income adjusted for inflation, which prevents them from losing purchasing power. Although such raises rarely match the whole % increase in inflation, certain union workers do obtain automatic cost-of-living adjustments (COLAs) in their salary when the CPI rises.
  • Borrowers. Individuals that borrow money may benefit from a rise in inflation levels. The reason for that is that inflation reduces the value of money. As such, those people who have borrowed money before inflation pay back less amount of money in real value.

Effects of Inflation - Key takeaways

  • Demand-pull inflation has many effects, such as reducing consumer purchasing power, increasing borrowing costs, and increasing the cost of living.
  • Cost-push inflation takes place when the cost of production in the economy rises.
  • Real return is the difference between the nominal interest rate and inflation.
  • The effects of inflation on consumers depend on whether the individual is a fixed-income receiver, saver, flexible-income receiver, or borrower.

Frequently Asked Questions about Effects of Inflation

Some of the main effects of demand-pull inflation include increased cost of living, drop in purchasing power, higher cost of borrowing, and lower unemployment.

Some of the primary effects of cost-push inflation include a decline in production, higher unemployment, and lower profits.

The effects of inflation on consumers depend on whether the individual is a fixed-income receiver, saver, flexible-income receiver, or borrower.

When there is inflation that results from the increase in consumer spending, there will be more demand for products, which raises the total production in the economy. As a result, there is lower unemployment.

Low-stable and predictable inflation can be good for the economy. However, unexpected and high-rate inflation harms the economy.

Final Effects of Inflation Quiz

Question

Menu costs are _______.

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Answer

the costs associated with changing listed prices.

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What do menu costs have to do with inflation?

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Answer

Menu costs are one of the costs that inflation imposes on the economy. Firms have to incur costs when they change their prices to catch up with the rising costs of other things.

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Question

What are some examples of menu costs?

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Answer

The time and effort spent on calculating the new prices.

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Question

How are shoe leather costs different from menu costs?

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Answer

Shoe leather costs refer to the time, effort, and other resources spent on converting currency holdings into something else due to the depreciation of money during inflation.


Menu costs are costs of changing listed prices.

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Question

What are examples of menu costs for a restaurant?

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Answer

The time and effort spent on calculating the new prices.

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What are examples of menu costs for a supermarket?

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Answer

The labor cost of changing the price tags on the shelf.

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Question

During times of very high inflation, firms might ______.

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Answer

have to change their prices very frequently.

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What are some ways that firms can lower menu costs?

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Answer

Using electronic price tags.

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How do menu costs explain price stickiness?

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Answer

Firms may want to keep their prices unchanged to avoid menu costs.

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Question

How will firms respond to demand shocks in a world of zero menu costs and perfectly flexible prices?

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Answer

They can just adjust their prices in response and keep their output and number of employed workers constant.

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Question

How do menu costs contribute to short-run macroeconomic fluctuations?

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Answer

Firms cannot easily adjust their prices due to menu costs. If they cannot respond to demand shocks through price adjustments, they have to change their output and employment levels.

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What happens when a restaurant cannot adjust its prices due to menu costs and is facing more demand than before?

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Answer

It has to hire more workers and increase its output to respond to the increased demand.

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What happens when a firm faces a negative demand shock?

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Answer

It would want to lower its prices, but if it can't do so due to menu costs, it might have to decrease its output and hire fewer workers.

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Question

When the economy is facing a general negative demand shock, menu costs might contribute towards a(n) _____.

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Answer

recession.

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When the economy is facing a general positive demand shock, menu costs might contribute towards a(n) ______.

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Answer

recession.

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Question

What are shoe leather costs?

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Answer

The effort that people go through to minimize the effects of inflation.

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What is inflation?

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Answer

The general increase in prices.

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What are menu costs?

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Answer

The costs that businesses incur when they change their listed prices due to inflation.

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What is deflation?

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Answer

The general decrease in prices.

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Question

True or False: Shoe leather costs occur with deflation.

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Answer

False.

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True or False: Shoe leather costs are most prominent with very high levels of inflation.

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Answer

True.

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True or False: Menu costs occur when people rush to the bank and try to exchange their domestic currency for a foreign one.

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Answer

False.

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True or False: The main difference between shoe leather costs and menu costs is that one occurs with deflation, the other with inflation.

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Answer

False.

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Shoe-leather costs are most prominent when inflation _________

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Answer

is very high.

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Menu costs occur when businesses _______ prices due to inflation.

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Answer

increase

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True or False: shoe-leather costs can occur with deflation.

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Answer

False.

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People are rushing to the bank to exchange their currency because of inflation! This is an example of:

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Answer

shoe-leather costs.

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Businesses are forced to raise their prices due to inflation! This is an example of:

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Answer

menu costs.

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True or False: Shoe-leather costs rarely affect banks.

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Answer

False.

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True or False: menu costs force the government to raise taxes.

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Answer

False.

Show question

Question

What is demand-pull inflation?

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Answer

Demand-pull inflation occurs when aggregate demand in the economy is higher than aggregate supply.

Show question

Question

What are some of the effects of demand-pull inflation?

Show answer

Answer

Demand-pull inflation has many effects, such as reducing consumer purchasing power, increasing borrowing costs, and continuing inflation growth. 

Show question

Question

Explain how demand-pull inflation increases the cost of living.

Show answer

Answer

When an economy is experiencing demand-pull inflation, there is an excessive money supply flooding the markets; however, there are limited goods and services available in the economy. When customer demand for various consumer items exceeds the available supply, demand-pull inflation begins to take effect. This results in an overall increase in the cost of living for consumers.

Show question

Question

The effect of the rise in the interest rate contributes to the ______ cost of borrowing.

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Answer

Higher

Show question

Question

Explain how demand-pull inflation lowers the unemployment rate.

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Answer

Because of the rapid increase in demand, businesses are expanding their workforce to meet the rising demand for their products. When companies hire additional workers, the number of individuals with jobs grows. At some point in time, the capacity of producers to provide consumer products will be outpaced by the demand for those things.

Show question

Question

A well-known example of cost-push inflation is what the United States economy experienced during the 1970s when the general price level rose even if the overall expenditure was not very high.

Show answer

Answer

True

Show question

Question

____ inflation takes place when the cost of production in the economy rises. 

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Answer

Cost-push

Show question

Question

What are some of the effects of cost-push inflation?

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Answer

Decline in production, higher unemployment, higher prices

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Which one of the following is not an effect of cost-push inflation?

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Answer

Higher production

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Question

What do the effects of inflation on customers depend on?

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Answer

The effects of inflation on consumers depend on: 
1. whether an individual is a fixed or flexible income receiver;
2. whether an individual is a saver or a borrower.

Show question

Question

Explain how inflation affects fixed-income receivers?

Show answer

Answer

When inflation occurs, those whose earnings are predetermined see a decline in the purchasing power of their dollars. Landlords who receive lease payments in the form of set dollar amounts may experience financial hardship due to inflation since the dollars they receive will have a decreasing value over time. Workers in the public sector, whose earnings are determined by set pay schedules, are susceptible to experiencing the adverse effects of inflation. 

Show question

Question

Explain how inflation affects flexible-income receivers?

Show answer

Answer

People with flexible incomes may be able to avoid the harmful effects of inflation or may even gain from it. Individuals whose income is linked to the Consumer Price Index have their income adjusted for inflation, which prevents them from losing purchasing power. Although such raises rarely match the whole % increase in inflation, certain union workers do obtain automatic cost-of-living adjustments (COLAs) in their salary when the CPI rises. 

Show question

Question

Explain how inflation affects savers.

Show answer

Answer

Savers are negatively impacted during times of inflation. The actual worth of an accumulation of savings, also known as its buying power, decreases due to rising prices. The real value of paper assets like savings accounts, insurance policies, and annuities declines. This is because inflation eats away at the purchasing power of these assets over time. However, this doesn't apply when the return on savings is higher than the inflation rate.

Show question

Question

Explain how inflation affects borrowers.

Show answer

Answer

Individuals that borrow money may benefit from a rise in inflation levels. The reason for that is that inflation reduces the value of money. As such, those people who have borrowed money before inflation pay back less amount of money in real value.

Show question

Question

What is real return?

Show answer

Answer

Real return is the difference between the nominal interest rate and inflation.

Show question

Question

Is today's money considered a unit of account?

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Answer

Yes

Show question

Question

Money ______ value during inflationary periods?

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Answer

loses

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What are the unit of account costs?

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Answer

The unit-of-account costs of inflation are costs associated with money becoming a less reliable unit of measurement.

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What's one of the main effects of the unit-of-account cost?

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Answer

One of the main effects of the unit-of-account cost is that it makes economic decisions less efficient in the economy by giving rise to uncertainty in the function of money as a unit of account.

Show question

Question

______is defined as a rise in the general level of prices. 

Show answer

Answer

Inflation

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