Inflation is the overall rise in the prices of goods and services over time. Inflation is the sustained and broad rise in the prices of goods and services over time, which erodes purchasing power.

Inflation is generally caused by an imbalance in supply and demand, supply shocks, and inflation expectations.

This makes it important to distinguish between the inherent effects of inflation at any rate and those that only come into play during periods when inflation runs unusually high. We’ll do that below by identifying inflation’s most important effects on consumers, investors, and the economy.

A small but positive inflation rate is economically useful, while high inflation tends to feed on itself and impair the economy’s long-term performance.

Inflation is the rise in prices of goods and services over a certain period. When prices rise, consumers lose purchasing power, which means the power of a single unit of currency doesn’t go as far as it did before. A little inflation isn’t much cause for concern but it can be when prices rise too quickly. But what causes this increase?

 

Below are 10 Effects of Inflation on the Nation’s Economy:

An imbalance in supply and demand. Inflation tends to increase when consumer demand for goods and services increases when supplies are limited at desirable price levels.

The disruption in supplies or supply shocks can trigger inflation. For instance, global energy prices jumped following Russia’s invasion of Ukraine. Russia cut off global energy supplies and tightened the market in response to sanctions placed by the international community. This drop in energy supplies caused prices to increase.

The expectations of inflation. When people expect prices to rise, they often demand higher wages to prepare for future price increases. Producers and businesses tend to respond by raising prices, which causes inflation to rise.

 

Now let’s take a look at some of the major impacts inflation has on the economy.

1. Inflation Erodes Purchasing Power

This is inflation’s primary and most pervasive effect. An overall rise in prices over time reduces the purchasing power of consumers since a fixed amount of money will afford progressively less consumption.

Consumers lose purchasing power regardless of what the inflation rate is—whether it’s 2% or 4%. This just means that they lose it twice as fast at a higher rate. Compounding ensures that the overall price level increases more than twice as much over the long run if long-run inflation were to double.

Inflation measures the rise in prices over time for a basket of goods and services representative of overall consumer spending. The Consumer Price Index (CPI) is the best-known inflation indicator, while the Federal Reserve focuses on the PCE Price Index in its inflation targeting.

2. Inflation Disproportionately Impacts Lower-Income Consumers

Lower-income consumers tend to spend a higher proportion of their income on necessities than those with higher incomes. This means they have less of a cushion against the loss of purchasing power inherent in inflation.

Policymakers and financial market participants often focus on core inflation. This measurement of inflation excludes the prices of food and energy because they tend to be more volatile and less reflective of the longer-term inflation trends. But earners with lower income spend a relatively large proportion of their weekly or monthly household budgets on food and energy—commodities that are hard to substitute or go without when prices spike.

The poor are also less likely to own assets like real estate, which has traditionally served as an inflation hedge.

On the other hand, recipients of Social Security benefits and other federal transfer payments receive inflation protection in the form of cost of living adjustments (COLA) based on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), which is an index of consumer prices for hourly wage earners and clerical workers.

3. Inflation Keeps Deflation at Bay

The Fed’s target inflation rate is set at 2% over the long run. This allows it to meet its mandates for stable prices and maximum employment. It focuses on modest inflation rather than steady prices because a slightly positive inflation rate greases the wheels of commerce, provides a margin of error in the event inflation is overestimated, and deters deflation. The overall decline in prices can be much more destabilizing than comparable inflation.

Lenders can charge interest to offset the inflation likely to devalue repayments. It also helps borrowers service their debts by allowing them to make future repayments with inflated currency. On the other hand, deflation makes it more expensive to service debt in real terms, since incomes would be likely to decline alongside prices.

One reason modest inflation (rather than deflation) is the norm is that wages are sticky to the downside. Workers tend to resist attempts to cut their wages during an economic downturn, with layoffs the likeliest alternative for businesses facing a downturn in demand.

A positive inflation rate allows a wage freeze to serve as a cut in labor costs in real terms.

The benefits of inflation are only insurance against deflation until price hikes exceed the customary and expected rate because inflation can also spiral out of control if high enough.

Because deflation represents a departure from the norm, it’s also more likely to trigger expectations for additional deflation, causing further spending and income declines and ultimately widespread loan defaults that can set off a banking crisis.

4. Inflation Feeds on Itself When It’s High

A little inflation can signal a healthy economy. As such, it’s not likely to cause inflation expectations to rise. If inflation was 2% last year and is 2% this year, it’s mostly background noise. Businesses, workers, and consumers would likely expect inflation to remain at 2% next year in that scenario.

However, expectations of future inflation will begin to rise accordingly when the inflation rate accelerates sharply and stays high. As those expectations rise, workers start demanding larger wage increases and employers pass those costs on by raising prices on output, setting off a wage-price spiral.

In the worst-case scenario, a bungled policy response to high inflation can end in hyperinflation. But there’s no need to count the cost of soaring inflation expectations in wheelbarrow loads of Zimbabwe dollar notes denominated in trillions or the Weimar Republic’s worthless marks from Germany’s five years of hyperinflation after World War I. In the U.S., rising inflation expectations during the 1970s lifted annual inflation above 13% by 1980 and the federal funds rate to more than 20% by 1981, while unemployment topped 10% as late as mid-1983 following the ensuing recessions.

5. Inflation Raises Interest Rates

As the examples above suggest, governments and central banks have a powerful incentive to keep inflation in check. The approach has been to manage inflation using monetary policy over the past century. When inflation threatens to exceed a central bank’s target (typically 2% in developed economies and 3% to 4% in emerging ones), policymakers can raise the minimum interest rate, driving borrowing costs higher across the economy by constraining the money supply.

As a result, inflation and interest rates tend to move in the same direction. By raising interest rates as inflation rises, central banks can dampen the economy’s animal spirits or risk appetite, and the attendant price pressures. The expected monthly payments on that boat or that corporate bond issue for a new expansion project suddenly seem a bit high. Meanwhile, the risk-free rate of return available for newly issued Treasury bonds will tend to rise, rewarding savings.

6. Inflation Lowers Debt Service Costs

While new borrowers are likely to face higher interest rates when inflation rises, those with fixed-rate mortgages and other loans get the benefit of repaying these with inflated money, lowering their debt service costs after adjusting for inflation.

Say you borrow $1,000 at a 5% annual rate of interest. If annual inflation subsequently rises to 10%, the annual decline in your inflation-adjusted loan balance will outweigh your interest costs.

Note that this doesn’t apply to adjustable-rate mortgages (ARMs), credit card balances, or home equity lines of credit (HELOCs), which typically allow lenders to raise their interest rates to keep pace with inflation and Fed rate hikes.

7. Inflation Lifts Growth & Employment in the Short Term

Higher inflation can lead to faster economic growth in the short term. While the 1970s are recalled as a decade of stagflation, U.S. real gross domestic product (GDP) increased 3.2% annually on average between 1970 and 1979, well above the economy’s average growth rate since.

Elevated inflation discourages saving since it erodes the purchasing power of the savings over time. That prospect can encourage consumers to spend and businesses to invest.

As a result, unemployment often declines at first as inflation climbs. Historical observations of the inverse correlation between unemployment and inflation led to the development of the Phillips curve expressing the relationship. For a time at least, higher inflation can spur demand while lowering inflation-adjusted labor costs, fueling job gains.

Eventually, though, the bill for persistently high inflation must come due in the form of a painful downturn that resets expectations, or else chronic economic underperformance.

8. Inflation Can Cause Painful Recessions

The trouble with the trade-off between inflation and unemployment is that prolonged acceptance of higher inflation to protect jobs may cause inflation expectations to rise to the point where they set off an inflationary spiral of price hikes and pay increases, as happened in the U.S. during the stagflation of the 1970s.

To regain lost credibility and convince everyone again it would control inflation, the Fed was subsequently forced to raise interest rates much higher and keep them high for a longer period. That, in turn, caused unemployment to soar, and to stay high for longer than would likely have been the case had the Fed not allowed inflation to spiral so high.

9. Inflation Hurts Bonds & Growth Stocks

Bonds are generally considered to be low-risk investments that provide regular interest income at a fixed rate. Inflation (especially high inflation) impairs the value of bonds by lowering the present value of that income.

As interest rates increase in response to rising or elevated inflation, so does the yield on newly issued bonds. The market price of bonds issued previously at a lower yield then drops proportionally, since bond prices are the inverse of bond yields. Investors with Treasury bonds are still in line for the expected coupon payments, followed by principal repayment at maturity. However, those who sell their bonds before maturity will receive less as a result of the increased market yields.

There is less of a consensus about whether high inflation hurts or helps stocks overall. Conclusions depend on the definition of high inflation and whether the historical record cited includes the 1970s, a lost decade for U.S. stocks amid stagflation.

Growth stocks, which tend to be more expensive, are notoriously allergic to inflation. Inflation discounts the present value of their future cash flows more heavily, just as it does for high-duration bonds. Technology and consumer stocks have lagged during past episodes of high or rising inflation.

10. Inflation Boosts Real Estate, Energy, & Value Stocks

Real estate has historically served as a hedge against inflation since landlords can protect themselves by raising rents even as inflation erodes the real cost of fixed-rate mortgages.

Rising commodity prices can cause inflation to accelerate. Once it does, commodities can change when growth slows. This is particularly true of energy commodities that tend to continue to outperform.

Unsurprisingly, energy equities, real estate investment trusts (REITs), and value stocks have historically outperformed during episodes of high or rising inflation.