Imagine you lend 1,000 dollars to your friend and agree that your friend will return your money the following year with zero interest. However, a supply shock causes the price of all goods in grocery stores to increase by 50%, which means that your $1,000 would be half of the goods you could buy when you lent the money to your friend. This is how inflation affects your money. How about the economy? What are some of the effects of inflation on the economy? Is inflation always bad? Read on to learn all there is about the effects of inflation and how to negotiate better deals when lending money to your friend next time.
Effects of Demand-Pull Inflation
Demand-pull inflation has many effects, such as reducing consumer purchasing power, increasing borrowing costs, and continuing inflation growth.
Rises in the general price level occur when the total production capacity of the economy is incapable of meeting the increase in demand for goods and services.
Demand-pull inflation occurs when aggregate demand in the economy is higher than aggregate supply.
Figure 1 shows some of the main effects of demand-pull inflation, including increased cost of living, drop in purchasing power, higher cost of borrowing, and lower unemployment.
When an economy is experiencing demand-pull inflation, there is an excessive money supply flooding the markets; however, there are limited goods and services available in the economy. When customer demand for various consumer items exceeds the available supply, demand-pull inflation begins to take effect. This results in an overall increase in the cost of living for consumers.
Fig. 2 - Demand-pull inflation
Figure 2 shows the demand-pull inflation using the AD-AS model. As the overall consumption in the economy increases, it causes the aggregate demand curve to shift from AD1 to AD2. The shift in the aggregate demand causes the price level to increase from P1 to P2 and the overall output produced (from Y1 to Y2).
When inflation is high and stays high for an extended period of time, the culprit is generally an excessive amount of money issued by the central bank (the Federal Reserve in the United States). At some point, the Federal Reserve will have to raise the interest rate in the economy to cool down the increase in aggregate demand.
The effect of the rise in the interest rate contributes to the higher cost of borrowing. This would leave individual consumers reducing their consumption and increasing their savings.
Also, in an environment characterized by demand-pull inflation, many consumers experience a reduction in their purchasing power. The supply of goods and services is limited, which bids up the price. The increase in price lowers the number of goods and services one can buy.
Imagine the price of all cars in the economy increased by 20% while the supply of new cars remained relatively steady. In such a case, one would lose 20% of their purchasing power when it comes to buying cars.
Another effect of demand-pull inflation is that the unemployment rate drops. Because of the rapid increase in demand, businesses are expanding their workforce to meet the rising demand for their products. When companies hire additional workers, the number of individuals with jobs grows. That's because businesses increase their capacity to produce by hiring more people to meet the demand increase.
Effect of Cost-Push Inflation
There are many effects of cost-push inflation. Disruption in the supply of goods and services also causes inflation in the economy. This type of inflation is known as cost-push inflation.
Figure 3 shows some of the main effects of cost-push inflation, including a decline in production, higher unemployment, and lower profits.
A well-known example of cost-push inflation is what the United States economy experienced during the 1970s when the general price level rose even if the overall expenditure was not very high.
The effects of cost-push inflation during these times were associated with a decline in production and a rise in unemployment. As production dropped and more people were unemployed, there was less income; hence, the spending in the economy plunged.
Cost-push inflation takes place when the cost of production in the economy rises.
Increasing prices may be broken down into the components that contribute to increased per-unit production costs at any given level of expenditure.
The average cost of producing a certain quantity of goods or services is referred to as the per-unit production cost.
This cost considers all the expenses a business incurs when producing a product.
Fig. 4 - Cost-push inflation
Figure 4 illustrates the cost-push inflation using the AD-AS model. As the cost of raw materials increases, the short-run aggregate supply curve will shift from SRAS1 to SRAS2, changing the equilibrium from E1 to E2. As a result of this shift, the overall prices in the economy increase from P1 to P2, and the output produced drops from Y1 to Y2.
In a cost-push inflation setting, many companies experience their profit drop due to the rise in per-unit manufacturing costs. As a result of the shrink in profits and higher cost of producing, companies lower their output produced.
As a direct consequence of this, the number of products and services available in the economy will fall, leading to an increase in overall prices.
Supply shocks have been the primary contributor to cost-push inflation during the last several decades. In particular, unexpected jumps in the pricing of inputs, such as raw materials or energy, led to a rise in both the overall costs of production per unit and the prices of finished goods.
A classic example of this is the rise in the price of imported oil in 1973–1974 and then again in 1979–1980. During these times, the cost of manufacturing and transporting almost every product in the economy increased, directly resulting from the sharp rise in the price of energy. The result was cost-push inflation.
We have an entire article dedicated to the 'Oil Crisis of 1973'. Feel free to check it out!
In the 'Causes of Inflation' article, we covered the leading causes of all types of inflation. Don't miss out!
Effects of Inflation on the Economy
The effect of inflation on the economy depends on the types of inflation the economy is experiencing. There are different effects when an economy is going through cost-push inflation, and other effects take place when the economy is going through demand-pull inflation.
To understand the effects of inflation on the economy, economists look at whether there is economic growth or more output produced in the economy.
It is crucial to remember that sudden and unanticipated increases in the cost of essential resources like oil may significantly push up total production costs, leading to cost-push inflation.
Individuals cut down on their consumption when there is an increase in the price of the goods and services they consume. As a result of the decrease in demand, businesses respond by reducing their overall production. As less production takes place, fewer workers are needed, which contributes to an increase in the unemployment rate.
During cost-push inflation, there is higher unemployment and less output produced in the economy.
During times of demand-pull inflation, robust levels of total expenditure are needed for full employment and economic development. As more money is in the economy and people are demanding products, more output will be produced. These kinds of expenditures result in large earnings, robust demand for labor, and an excellent incentive for businesses to increase the size of their facilities and the quantity of their machinery.
However, some economists believe that inflation reduces output as individuals dedicate more time to activities that will enable them to hedge against inflation. People will have to spend more time learning about the change in interest rates, prices, and wages. Businesses will also have to spend a considerable amount of time and money adjusting their prices. The productive time gets lost as this time does not contribute to increasing economic output.
Effects of Inflation on Bank's Profitability
Banks work by lending money to individuals in need and charging them a certain amount for the time they used the bank's money, known as the interest rate. As such, inflation's effects on bank profitability are strongly related to whether or not the inflation rate is higher than the interest they charge on a loan.
Real return is the difference between the nominal interest rate and inflation.
The real return one gets on an asset depends on whether or not the interest (return) on that asset is higher than the current rise in price (inflation).
Assume that you lend 10,000 dollars to your friend and agree that they will return 10,500$ next year, which is a 5% return on your loan. However, inflation in the economy is 10%, which means that the prices of all goods and services in the economy increased by 10%. This means that you need $11,000 to buy the same amount of goods and services the following year. This means you lose $500 ($11,000-$10,500), or 5% of your real worth, from lending money to your friend.
The same scenario applies to banks' profitability when the economy is going through inflation. As a result of inflation, the money loses value, but the bank has already agreed to lend a certain amount. Therefore, the money the bank gets after inflation is lower in value when compared to the money it lent. As a result, inflation lowers the bank's profitability.
Effects of Inflation on Consumers
The effects of inflation on consumers depend on whether the individual is a fixed-income receiver, saver, flexible-income receiver, or borrower.
- Fixed-income receiver. When inflation occurs, those whose earnings are predetermined see a decline in the purchasing power of their dollars. Landlords who receive lease payments in the form of set dollar amounts may experience financial hardship due to inflation since the dollars they receive will have a decreasing value over time. Workers in the public sector, whose earnings are determined by set pay schedules, are susceptible to experiencing the adverse effects of inflation.
- Savers. Savers are negatively impacted during times of inflation. The actual worth of an accumulation of savings, also known as its buying power, decreases due to rising prices. The real value of paper assets like savings accounts, insurance policies, and annuities declines. This is because inflation eats away at the purchasing power of these assets over time. However, this doesn't apply when the return on savings is higher than the inflation rate.
- Flexible-Income Receivers. People with flexible incomes may be able to avoid the harmful effects of inflation or may even gain from it. Individuals whose income is linked to the Consumer Price Index have their income adjusted for inflation, which prevents them from losing purchasing power. Although such raises rarely match the whole % increase in inflation, certain union workers do obtain automatic cost-of-living adjustments (COLAs) in their salary when the CPI rises.
- Borrowers. Individuals that borrow money may benefit from a rise in inflation levels. The reason for that is that inflation reduces the value of money. As such, those people who have borrowed money before inflation pay back less amount of money in real value.
Effects of Inflation - Key takeaways
- Demand-pull inflation has many effects, such as reducing consumer purchasing power, increasing borrowing costs, and increasing the cost of living.
- Cost-push inflation takes place when the cost of production in the economy rises.
- Real return is the difference between the nominal interest rate and inflation.
- The effects of inflation on consumers depend on whether the individual is a fixed-income receiver, saver, flexible-income receiver, or borrower.
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