Reports about the current inflation rate are often met with pessimism. However, at a certain level, a general increase in the price of goods and services in an economy over time is considered normal and even an indicator of economic growth. Excessive inflation is still problematic because it erodes the purchasing power of the consumers and can result in economic instability. There are also instances in which inflation has become uncontrollable and has resulted in a phenomenon called hyperinflation. Countries like Venezuela and Zimbabwe have been experiencing double-digit to triple-digit inflation rates. These have resulted not only in economic uncertainties but also in social and political instability. This article discusses the advantages and disadvantages of inflation.
Understanding the Positive and Negative Economic and Social Impacts of Inflation: The Ups and Downs of Increasing Prices
Pros of Inflation: Advantages and Notable Positive Impacts
Inflation is the gradual rise in the prices of goods and services. This transpires even in the most robust economies because economic growth often results in an increase in the demand for goods and services and also compels businesses to raise salaries and wages to attract employees. These two represent two of the four causes of inflation. Hence, when it is moderate and stable a general increase in prices can be considered good. Below are the advantages and positive impacts:
1. An Indicator of Economic Growth
Moderate increases in the prices of goods and services over time are normal in a growing economy. This is because economic growth is a result of growth in business activities. The increase in these activities also increases the demand for labor. This then gives more people with purchasing power. The result is an increase in businesses producing more and consumers spending more. Inflation is essentially an inevitable consequence of economic productivity.
Inflation specifically occurs in a growing economy due to an increase in aggregate demand. This is driven by the growth in the purchasing power of consumers. The expansion of business activities and increase in demand for labor create an upward pressure on salaries and wages. This creates more demand due to the further increasing purchasing power of consumers. Businesses also pass the additional labor cost on to consumers through price increases.
2. Encourages Spending and Investment
Another positive impact of inflation is that it can encourage spending and investment. Most people prefer spending or investing their cash rather than saving when inflation is expected. This is due to the well-accepted notion that holding cash is counterproductive because it will lose value over time because of the gradual increase in the prices of goods and services. Spending maximizes the current value of cash while investing can help in growing its value.
The growth in spending and investing activities can drive economic growth. This is especially true when inflation is moderate and predictable. An increase in spending creates a multiplier effect because it stimulates aggregate demand further and induces businesses to increase their outputs through expansions to create an adequate level of supply. An increase in investing activities, on the other hand, creates more capital for business expansion.
3. Reduction in Real Debt Burden
The real value of debt is tied to the current real value of cash. However, because of inflation, the real value of debt decreases. This benefits borrowers with medium-term to long-term debts under a fixed nominal payment structure. Those with outstanding debts, such as individuals, businesses, and governments, are essentially repaying their debt obligations using cheaper cash. This is due to the fact that inflation erodes the real value of money over time.
Consider owing USD 1000 as an example that is payable in 5 years for USD 250 each year. This amount becomes less significant in terms of real purchasing power over time with inflation. The benefit of inflation for borrowers becomes truer with the gradual or significant rise in their salaries and wages. This also means that the gradual erosion of money is unfavorable to lenders. Take note that deflation, the opposite of inflation, increases the real value of debt.
Cons of Inflation: Disadvantages and Key Negative Impacts
The main drawback of inflation is that it erodes the purchasing power of consumers and renders a currency less valuable time. An excessive and uncontrollable increase in the prices of goods and services can also bring forth economic instability and social and political uncertainties. There are instances in which prolonged periods of high inflation have resulted in economic collapse and sociopolitical upheavals. Below are the disadvantages and negative impacts:
1. Decrease in Purchasing Power Over Time
Sustained inflation decreases the purchasing power of consumers over time. It erodes the value of their cash. The gradual increase in prices of goods and services means that people are buying less with the same amount of money. This is also true even when price increases remain stable and moderate. The eroding value of cash results in a lower standard of living for those with fixed income like retirees or when salaries and wages do not increase with inflation.
Businesses also face increased costs because of inflation. Examples of these costs include utilities, rentals, labor, and supplies, among others. Hence, to maintain an adequate level of profits, businesses pass these costs to the consumers by increasing the prices of their products. This further aggravates inflation and can even result in runaway inflation and hyperinflation. The situation becomes dire in periods of high and prolonged price increases.
2. Economic Uncertainties and Instability
Another disadvantage of inflation is its multi-fold negative economic impacts. It can distort price signals and make it harder for consumers and businesses to determine the true value of goods and services. This can lead to inefficient resource allocations. It can also erode the value of a currency and make imports more expensive. Inflation also erodes the value of savings. This affects not only account holders but also the performance of banking institutions.
Note that high and prolonged increases in the price of goods and services can lead to a wage-price spiral in which workers demand higher salaries and wages, which in turn leads to businesses increasing their prices. A central bank will also increase interest rates to decrease demand and control prices. This raises the cost of borrowing for consumers and businesses. It can slow economic growth because of reduced consumption and business activities.
3. Specific Social and Political Consequences
Price increases also exacerbate inequality because they disproportionately affect people with lower or fixed incomes with fewer resources to cope. Affected individuals may spend less on healthcare, education, and other social services. Their overall quality of life declines. On the other hand, wealthier individuals who hold inflation-protected assets are insulated from the negative impacts of inflation. This widens the gap between the rich and the poor.
The failure to keep prices stable often fuels political discontent. This can further result in political instability and political polarization. Affected people would be drawn to anti-establishment movements and populist figures. Uncontrolled inflation also increases the likelihood of hyperinflation. The experiences of countries like Venezuela and Zimbabwe demonstrate how this situation can also create pressing social and political upheavals.