7.6: How Inflation Affects the Economy

The effects inflation has on the economy and market participants can be put into two categories.

1. moderate and stable inflation
2. high and volatile inflation

Let's discuss each of them.

Moderate Inflation

The word moderate is a relative term that raises some important questions, such as

• Who: The consumers who buy goods and services that are rising faster in price bear a greater burden of inflation.
• What: What inflation measure is being examined? One type of inflation may exhibit volatility while another, slightly different measure changes very little.
• When: When was the pricing data collected? It is important to distinguish between temporary and permanent changes to the long-term inflation trend. There have been short periods of time in every economy's history that saw sudden changes in the average price level. By only examining those periods, one might develop a distorted view on the future long-term inflation trend.

When examining the pros and cons of inflation, it is essential to specify the market participant, type of inflation indicator, and time period. Unless it is specifically noted, we will be using the U.S. consumer as the market participant and the CPI as the indicator to frame this lecture's examination of inflation.

In the United States, an annual inflation rate of 2 to 4 percent is considered moderate. And when inflation is predictably low, buyers and sellers can make adjustments to counteract inflation's redistribution effects. For example, those living on fixed incomes, such as welfare recipients or retirees, can be protected from rising prices and falling purchasing power through appropriate policy action, such as cost-of-living increases. This can only happen when inflation is moderate and predictable. After all, how can anyone determine the proper cost-of-living increase when the future rate of inflation is unknown?

Since the 1990s the U.S. inflation rate has been around 2.5 percent.

Figure 3

There is ample evidence that there are few substantive costs associated with a moderate (and expected) rate of inflation, which is why the Federal Reserve, the U.S. inflation watchdog, does not have a 0 percent inflation target. The Federal Reserve's inflation target is 2%, measured by the Personal Consumption Expenditures (PCE) Price Index. This target aims to promote price stability and support sustainable economic growth.

Inflation becomes problematic when changes in the average price level are sudden and extreme or when the rate remains persistently high. If the inflation rate is unpredictably volatile, market participants cannot take precautions against harmful income and wealth redistribution (harmful in the sense that their own income and wealth are being redistributed). This uncertainty can lead to economic contraction.

Here are some examples of how a high and volatile inflation rate can harm businesses and individuals:

• Inflation can make people worse off if their incomes do not rise as quickly as prices.
• Lenders may lose because they will be repaid with dollars that have less purchasing power.
• Savers may lose because the money they save today will buy less in the future.
• Businesses may struggle to plan ahead, leading to reduced investment in future projects.
• Owners of financial assets may suffer losses.
• Interest rate-sensitive industries, such as mortgage companies, may be negatively affected as inflation drives up long-term interest rates and Federal Reserve tightening raises short-term rates.

During the 1970s, the U.S. experienced both volatile and high rates of inflation. Compare the inflation rate in the graphic in figure 4 to the average rate in figure 3.

Figure 4