If you had $1000 right now, what would you buy? If you were given another $1000 next year, would you be able to buy that same thing again? Probably not. Inflation is, unfortunately, something that almost always happens in an economy. But the issue with it is that you end up paying an inflation tax without even knowing it. The same thing you buy now will be more expensive next year, but your money will be worth less. How is that possible? To find out the answer to this question along with the answers to who is most affected by inflation tax, the causes, and more, read ahead!
Inflation tax definition
As a result of inflation (the opposite of deflation), the cost of goods and services rises, but the value of our money decreases. And that inflation is accompanied by inflation tax. To be clear, the inflation tax is not the same as income tax and has nothing to do with the collection of taxes. Inflation tax isn't really visible. That's why preparing and planning for it may be extremely difficult.
Inflation is when the cost of goods and services rises, but the value of money decreases.
Deflation is negative inflation.
Inflation tax is a penalty on the cash you possess.
Fig 1. - Loss of Purchasing Power
As the rate of inflation rises, the inflation tax is the penalty on the cash you possess. Cash loses purchasing power as inflation grows. As Figure 1 above shows, the money you're holding onto is no longer worth the same amount. While you might have $10, you might actually only be able to purchase $9 worth of goods with that $10 bill.
Inflation tax example
Let's go through an example to show you what inflation tax looks like in the real world:
Imagine you have $1000 and you want to buy a new phone. The phone costs exactly $1000. You have two options: buy the phone immediately or put your $1000 in a savings account (that accumulates 5% interest per year) and buy the phone later.
You decide to save your money. After one year, you have $1050 in your savings thanks to the interest rate. You've gained $50 so that's a good thing right? Well, in that same one year the rate of inflation went up. The phone you want to buy now costs $1100.
So, you gained $50 but now have to cough up another $50 if you want to buy the same phone. What happened? You just lost the $50 you gained and had to give an extra $50 on top. If you had just bought the phone immediately before the inflation set in, you would have saved $100. Basically, you paid the extra $100 as a "penalty" for not buying the phone last year.
Inflation tax reasons
Inflation tax is caused by a number of factors, including:
Seigniorage - this occurs when the government prints and distributes additional money into the economy and uses that money to acquire goods and services. Inflation tends to be higher when the money supply is increased. The government may also raise inflation by lowering interest rates, which results in more money entering the economy.
Economic activity - inflation can also be caused by economic activity, especially when there is a greater demand for goods than there is supply. People are generally prepared to pay a higher price for a product when the demand exceeds the supply.
Businesses increasing their prices - inflation may also occur when the cost of raw materials and labor rises, prompting firms to raise their prices. This is what's known as cost-push inflation.
Cost-push inflation is a type of inflation that occurs when prices go up due to the cost of production going up.
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