What are the Positive Effects of Inflation?

While inflation is often viewed negatively, moderate levels of inflation can have some beneficial effects on the economy.

Stimulates Economic Growth

Moderate inflation can encourage spending and investment, as consumers and businesses may prefer to buy goods or make investments now rather than wait for prices to increase. The rationale behind this is that spending and investment are better than hoarding cash, which loses value over time. For example, in the post-2008 financial crisis period, many central banks, including the Reserve Bank of Australia (RBA), maintained low interest rates and targeted moderate inflation to encourage spending and investment, which helped to revive economic growth.

The following graph represents this, as both curves increase and decrease at a similar volatility:

As we can see in the graph, there are only a few instances where economic growth and inflation do not follow a similar trend.

Reduces the Real Value of Debt

Another positive effect of inflation is that it reduces the real value of debt. When prices rise, the real burden of debt decreases, benefiting borrowers who repay their loans. For example, during periods of moderate inflation, homeowners with fixed-rate mortgages benefit as the real value of their mortgage payments decreases over time. For instance, if inflation is 2-3% annually, the real value of mortgage debt diminishes, making it easier for borrowers to repay their loans.

A more specific example can be determined from an actual inflation rate. With Australia's average inflation rate of 2.5% between 2000 and 2020, a $100,000 fixed-rate loan taken out in 2000 would be equivalent to about $78,000 in 2020 dollars.

Increases Nominal Wages

In an inflationary environment, nominal wages tend to rise, which can boost consumer confidence and spending. Inflation also allows for easier adjustments of relative prices and wages. In a low-inflation environment, it is challenging for businesses to reduce real wages without cutting nominal wages, which can lead to worker dissatisfaction. For example, businesses can increase nominal wages at a slower rate than inflation. This effectively reduces real wages without cutting nominal wages. This flexibility can help businesses manage labour costs without causing significant employee unrest.

What are the Negative Effects of Inflation?

While moderate inflation can have some benefits, high or unpredictable inflation can have significant negative impacts on the economy and society. There are generally more negative effects of inflation than there are positive.

Reduces Purchasing Power

As prices rise, the real value of money declines, meaning consumers can buy fewer goods and services with the same amount of money. For example, if the inflation rate is 5%, and your salary does not increase accordingly, the purchasing power of your income decreases. For instance, if you could buy a basket of goods for $100 last year, the same basket would cost $105 this year. These effects can be specifically shown in Australia's economy, as $100 in 2000 would only buy the equivalent of $78 worth of goods in 2020.

Creates Economic Uncertainty

High and unpredictable inflation can create uncertainty in the economy, making it difficult for businesses and consumers to make long-term financial plans. This uncertainty can lead to reduced investment and economic instability. During periods of hyperinflation, extreme price volatility makes it nearly impossible for businesses to plan for the future, leading to economic collapse and severe social consequences.

Increases in the Cost of Borrowing

To combat high inflation, central banks often raise interest rates, increasing the cost of borrowing for businesses and consumers. For example, the RBA increased the cash rate from 0.1% in May 2022 to 4.1% in June 2023 to combat rising inflation of 7.8%. This significantly increased the borrowing costs for the household sector, as repayments become more expensive.

Impacts on Income Distribution

Inflation can have uneven effects on different income groups, potentially exacerbating income inequality. For example, in Australia, the bottom 20% of households by income spend a larger proportion of their income on necessities like food and housing. In other words, this group has a higher marginal propensity to consume. This is a problem as lower income earners become more susceptible to inflation, compared to the top 20% of income earners. As a result, the wealth gap between income "classes" only grows.

Hurts Savers

Inflation erodes the real value of savings. When the inflation rate is higher than the interest rate on savings accounts, the real return on savings is negative, meaning savers lose purchasing power over time. For example, if the interest rate on a savings account is 1% and the inflation rate is 3%, the real return on savings is -2%. This situation discourages saving and can lead to lower levels of investment and economic growth in the long term.