Effects of Inflation

Inflation affects the price of goods and services, real income (money received through work and investments), and real interest rates (the cost of borrowing money).

Inflation means that there is a sustained increase in the general price of goods and services. One of the effects of inflation is the decrease in purchasing power, or the amount of goods and services that one unit of money can buy. A 3% inflation rate means that $1.00 from last year is only worth $0.97 this year.

Income is money or a money equivalent received through the selling of capital, including land or labor, or through investments. When inflation is on the rise, real income falls. Those most affected by inflation are the elderly (who rely on fixed incomes; even if prices rise, their incomes stay the same, so they are able to purchase less) and low-income families (who may no longer be able to afford basic needs).

Inflation also affects the real interest rate, which is cost of borrowing money, expressed as a percentage of the amount borrowed; or, equivalently, the return on savings. The term real means that the value is adjusted for (or takes into account) inflation. For example, the real interest rate is the nominal interest rate minus inflation. In this sense, nominal refers to the current value, without adjusting for inflation. Interest is the money earned on investments, such as savings accounts. When the nominal interest rate on savings accounts is less than the inflation rate, then the real interest rate for the savings account is negative. People who count on interest for income are now poorer.

Interest is also the cost of borrowing money. A person who takes out a loan must repay the principal (amount of the original loan) plus interest (a percentage of the loan determined by the interest rate). When inflation is expected to rise, financial institutions such as banks may increase the cost of borrowing money, making it more expensive for individuals and businesses to take out loans and invest.

Inflation also impacts loans in other ways. For example, a person takes out a loan for $1,000. If inflation is rising, the $1,000 he or she repays in the future is not worth as much as when the loan was first taken. This means that inflation will help the borrower because he or she is paying the loan back with dollars that are worth less than those that he or she borrowed.

Hyperinflation is extreme inflation in which prices spiral out of control as supply cannot keep up with demand. It occurs during periods of great economic stress, such as in the aftermath of wars, in times of sociopolitical upheavals, or a collapse in export prices. While the effects of normal inflation may be beyond the notice of anyone other than economists, the effects of hyperinflation are extreme and noticeable by anyone. Hyperinflation annihilates the purchasing power of currency, which can lead to a hoarding of non-monetary assets and elimination of investment. Investors whose worth was in monetary investments may find that their assets evaporate. Stable foreign currencies may be substituted for local currency, as may precious metals. Governments may enact policies to counteract hyperinflation, but these often do little to stop the spiral.