Benefits of Inflation: How It Drives Economic Growth

The term “Inflation” describes the impact of rising oil or food prices on the economy. It’s a complex and crucial economic concept with varied interpretations. Many experts believe moderate inflation encourages spending, which is crucial for economic growth.

The Federal Reserve targets low long-term inflation, believing it supports business profitability and discourages delayed consumer purchases. There are some, in fact, who believe that the primary function of inflation is to prevent deflation.

Critics say inflation can harm the economy, as rising prices make saving difficult and drive people to riskier investments. Some claim that inflation benefits some businesses or individuals at the expense of others. Inflation poses challenges, like increased living costs, but it can stimulate spending and investment.

Key Takeaways

• Moderate inflation is necessary to drive consumption and support economic growth.
• The Federal Reserve targets a low, stable inflation rate to prevent consumers from delaying purchases.
• Inflation can benefit debtors, as loans are repaid with less valuable money over time.
• Inflation encourages spending and can increase production when the economy isn’t running at full capacity.
• While high inflation erodes purchasing power, a small amount can be economically beneficial.

Understanding Inflation

Inflation is a term often used to describe the impact of rising oil or food prices on the economy. For example, if the price of oil goes from $75 a barrel to $100 a barrel, input prices for businesses will increase and transportation costs for everyone will also increase. This may cause many other prices to rise in response.

Most economists define inflation as the result of more money in circulation, which reduces its value and raises prices.

Important

The Federal Reserve targets a 2% inflation rate over the long term, believing slow and steady price increases help to encourage business activity.

Inflation’s Effect on Purchasing Power

The primary impact of inflation is on purchasing power, which it erodes over time. The same amount of money buys less and less as prices rise. Even with wage adjustments, people often spend more of their income on groceries, rent, and other expenses.

Federal Reserve Strategies to Combat Inflation

Prolonged inflation often leads the Federal Reserve to raise the federal funds rate to slow it down. Higher federal funds rates raise borrowing costs, making it less appealing for businesses and individuals, affecting credit card rates.

Less borrowing usually means less spending. Companies often sell fewer products. That, in turn, leads to a slower economy, which should slow down the pace of price rises. However, a slowing economy may also lead to diminished corporate profits, layoffs, and income pressures on households.

The end result of this cycle of events potentially can be a recession. For that reason, the Federal Reserve tries hard to balance the need to stem inflation with the need to maintain acceptable levels of unemployment.

How Inflation Can Positively Impact the Economy

When the economy is not running at capacity, meaning there is unused labor or resources, inflation theoretically helps increase production. More dollars translates to more spending, which equates to more aggregate demand. More demand, in turn, triggers more production to meet that demand.

British economist John Maynard Keynes believed that some inflation was necessary to prevent the Paradox of Thrift.

This paradox states that if consumer prices are allowed to fall consistently because the country is becoming too productive, consumers learn to hold off on their purchases to wait for better deals. The net effect of this is to reduce aggregate demand, leading to less production, layoffs, and a faltering economy.

Economists once believed an inverse relationship existed between inflation and unemployment, and that rising unemployment could be fought with increased inflation. This relationship was defined by the famous Phillips curve. The Phillips curve was somewhat discredited in the 1970s when the U.S. experienced stagflation.

Who Benefits?

Inflation makes it easier on debtors, who repay their loans with money that is less valuable than the money they borrowed. This encourages borrowing and lending, which again increases spending on all levels.

For example, if a debtor has $10,000 of debt during an inflationary period, that debt has less worth as time progresses. From a purchasing power standpoint, it’s more advantageous to slowly pay off this debt during highly inflationary periods due to the debt’s diminishing value.

• Homeowners who have long-term, fixed-rate mortgages may benefit from inflation. As inflation rises, the outstanding mortgage’s value declines. As a result, the pace of repayment can increase.

• Because of the slowing economy and risk of recession, individuals who have job tenure or are in more secure positions often benefit. People in positions of less demand or startup departments/companies are more at risk from corporate budget cuts.

• When a nation’s inflation rate rises, the purchasing power of its currency often weakens against other international currencies. Those owning foreign currency then can take advantage of potentially favorable exchange rates.

Fast Fact

Inflation is constantly changing. Investors, consumers, and individuals should be aware of how one month’s inflation and government policies may differ from prior periods.

Challenges and Risks of High Inflation

Inflation can signal trouble for the economy and consumers. Consumers face rising prices, decreasing purchasing power, and an escalating risk of layoffs. This is especially true for those who do not receive salary or wage increases that keep up with the cost of living.

Consumers trying to make large purchases may be priced out of the market when inflation is high. As mentioned, when the Federal Reserve raises rates, the cost of debt usually increases. This can stop many prospective homebuyers from searching for a new home because they may not be able to afford the higher monthly payments.

Inflation harms consumers with fixed-term contracts that don’t permit wage increases.

The same goes for investors with fixed-income securities, especially longer term bonds. The rising interest rates associated with inflation decrease the value of bonds held in a portfolio. Selling them would result in a loss. So unless they have short terms or they’re being held to maturity, bonds with fixed interest rates usually will be less attractive to investors during periods of inflation.

Inflation’s Impact on Social Security Payments

Retirees face major challenges as inflation erodes the purchasing power of their monthly Social Security benefit payments. These payment amounts don’t change and may represent the only income many retirees receive.

To combat this deleterious effect, the Social Security Administration (SSA) increases benefits annually using its cost-of-living adjustment (COLA). Unfortunately, benefit increases often lag the inflation rate, so retirees must absorb price increases, which means they’ll have to do with less.

How Does the Government Measure Inflation?

In the U.S., the Bureau of Labor Statistics (BLS) publishes the monthly Consumer Price Index (CPI). This is the standard measure for inflation, based on the average prices of a theoretical basket of consumer goods.

What Causes Inflation?

Milton Friedman famously described inflation as the result of “too much money chasing too few goods,” resulting in higher prices. Inflation can sometimes be the result of an increase in the money supply due to government spending. It can also be the result of increased demand or a shortage of consumer goods. Following the COVID-19 pandemic, inflation rose sharply in the United States, largely due to supply chain bottlenecks and emergency government spending, including stimulus checks sent to households.

What Is the Inflation Rate?

The U.S. inflation rate, as represented by the CPI, was a year-over-year 2.4% in September 2024. It was the smallest 12-month increase since February 2021.

How Can I Benefit From Inflation?

Several investments are tied to CPI measurements or prevailing inflation rates. By owning these investments, you’re essentially guaranteed a nominal return (though the real return may be very marginal). In addition, inflation often puts buying pressure on households due to higher prices and the heightened cost of debt. To take advantage of this situation, consumers may be wise to reserve money during lower inflation periods so they have greater purchasing power during high-cost debt periods.

The Bottom Line

During inflationary periods, some parties benefit while others face increasing financial risks. For many, inflation can be frightening, given its ability to erode purchasing power. For others, inflation is necessary to grow the economy. Moderate inflation can stimulate spending and economic activity by encouraging consumption and preventing deflation. Inflation can benefit debtors and certain businesses, while posing risks to savers and fixed-income earners.

The Federal Reserve manages inflation through monetary policy. The Fed continues to maintain its 2% target for inflation.

Understanding inflation’s impacts on purchasing power, wage adjustments, and the cost of borrowing is crucial for personal financial planning.