The consequences of inflation
- High and volatile inflation brings uncertainty and increases risks, thus hampering economic growth.
- Inflation leads to a loss of people's purchasing power; it can make people poorer.
- High inflation or high inflation expectations can make companies more risk averse and less inclined to make long-term investments.
In Germany in 1923, prices doubled every two days and workers were paid twice a day so they could buy food and goods before prices rose again. This is one of history's most spectacular examples of the negative consequences of inflation.
High and volatile inflation is harmful for the economy, consumers and businesses. Keeping inflation at a low level is a goal of economic policy-makers around the world.
But what exactly does inflation mean for a society?
Volatility and uncertainty
Inflation does not cause major problems as long as inflation rates are low, stable and within the expectations of business and consumers. However, an important effect of inflation is the uncertainty it brings when the inflation rate is volatile, i.e. when price changes vary significantly over time. Volatile inflation can be caused by sharp swings in supply and/or demand in the economy, for example for raw materials such as agricultural products or oil which are fundamental for many aspects of daily life and work.
Volatile and unpredictable inflation rates make it difficult for consumers and businesses to plan over the long term. Thus, they discourage investments and savings and create inefficiencies in the market.
Inflation and consumers
A key effect of inflation is that it reduces the value of money with time, which means that money, and the owner of that money, suffer a loss of ‘purchasing power’. If the price of bread rises year on year, then less bread can be purchased for the same amount of money or more money must be paid for the same loaf of bread. Generally speaking, when prices rise, people’s income loses its purchasing power – they can buy fewer goods, take shorter holidays abroad and generally make do with less if their incomes do not rise at the same pace. This loss of purchasing power not only affects consumers and households, but it also has consequences for businesses and governments.
A further consequence of high inflation or high inflation expectations is that people are less inclined to save money for the future. This is because inflation could erode the purchasing power of savings with time. In this case, people who may in fact want to save for the future, in practice prefer to spend their money now.
Inflation and borrowers
Most people aspire to owning their own home, and borrowing money through a mortgage from a bank is the usual way to achieve this. Mortgages are repaid over many years, and the level of interest rates is generally linked to the inflation rate. However, if there is uncertainty about future inflation, lenders may want to ‘insure’ themselves against future higher-than-expected inflation by increasing interest rates or lending at a variable interest rate. So, while loan repayments might seem to be manageable at the moment the loan is granted, with a variable interest rate, a volatile inflation rate in later years can lead to sharp rises in the regular repayments from the household budget. The prospect of a volatile inflation rate introduces much uncertainty into what is, perhaps, the largest household expenditure of all. As a result, when inflation is high and volatile, borrowers face higher uncertainty and sometimes higher costs – whether these are young families buying their first home, small businesses wanting to expand, or governments wanting to borrow to build hospitals or roads.
The consequence of high and volatile inflation on borrowers is that economic decision-making becomes more risky, costs are higher, and choices are more limited.
Inflation and businesses
To thrive and grow businesses generally need benign economic conditions, including low and stable inflation. This is because businesses plan their activities and investments, such as in new machinery and manufacturing plants, for some years ahead. Indeed, for large companies, investment planning can cover decades into the future. It brings huge uncertainties into business planning if inflation is high or expected to be so, as the changing value of money means that companies cannot be sure of their future costs or revenues. In response, they become much more cautious.
High inflation or high inflation expectations can cause business costs to rise faster than productivity gains and lead entrepreneurs to become risk-averse, less willing to invest in the future – thereby reducing competitiveness. This has a negative impact on economic growth and employment.
Inflation and the EU
The decades before the introduction of the euro were characterised by high and volatile inflation, high borrowing costs and relatively low job creation. This is why one of the EU's and its Member States' key objectives is to keep inflation low and stable. During preparations for the euro, and subsequently after its adoption, an environment with low and stable inflation was created (Inflation and the EU).