7.5: Some Principles of Inflation

Inflation doesn't treat everyone equally, although you'd never know it by listening to people talk about it. When the issue of inflation comes up in casual conversation between neighbors or coworkers, it is usually discussed in a negative manner. Seldom do you hear anyone say, "Thank goodness for inflation." However, when you think about it, inflation in and of itself is neither good nor bad. When your home appreciates in value, do you curse the economic gods for your misfortune? No, of course not. In this case inflation is working in your favor.

It is important to realize that all income is generated from the sale of goods and services. This is a direct consequence of the income circular flow; a price paid by one person is generating an income for another person. And, as the average price level rises, so does the average income, as you can see from this chart.

Figure 2

Wages rise faster than prices when productivity increases and more slowly when non-wage costs (payroll taxes, health benefits, and so on) increase.

Inflation's impact on individuals varies dramatically based on their economic position, with two critical mechanisms - redistribution and uncertainty effects - fundamentally reshaping both personal finances and the broader economy; these twin forces create winners and losers across society depending on factors such as income sources, debt levels, and asset holdings, making inflation not merely an economic phenomenon but a significant social force with far-reaching consequences for household stability, business planning, and long-term economic prosperity.

Redistribution

A change in prices alters income and wealth. This can and often does have a significant impact on the lives of all people. Let's look at two scenarios of redistribution.

• Income redistribution: Income is linked to prices. When some prices rise, so do some incomes. For example, if students pay higher tuition costs, then income is being redistributed from students to the university. Consequently, real incomes generated at the university rise while those of the students (or their parents) fall.
• Wealth redistribution: A similar type of redistribution occurs between those who hold some form of wealth and those who don't. On average, people who purchased stocks in 1987 saw the stocks' value increase 326 percent over a ten-year period. Not too shabby! However, not all assets fared as well as stocks. During that same time, the overall value of gold fell 26 percent. Now, if we compare the performance of these two assets to the rise of the overall inflation rate (up 41 percent), we can draw the following conclusion: wealth was effectively redistributed from people who owned gold to people who owned stocks and other assets that appreciated faster than the inflation rate.

A prerequisite for long-term planning is stability. Without stability, people are unwilling to invest in the future. Sudden and unexpected changes in price levels create uncertainty and make economic decisions more difficult. Imagine a firm that's considering building a new plant. Let's assume that it will take two years before all aspects of construction and planning are complete. The firm bases its decision of whether to go ahead with the project on the plant's estimated costs of construction and operation, and on future revenues. If construction prices have a history of wild fluctuations, the firm owners, faced with this added uncertainty, may decide not to build the new plant.

When market participants become less certain about the future, the economy is unlikely to experience substantial long-term growth. This is a direct result of people shortening their time horizons in the face of inflation uncertainties.