For people and families, inflation means more expensive tomatoes, gas and car repairs — and nobody likes rising prices. But inflation’s effect on the economy as a whole isn’t so cut and dry.
“When considering the potential impact of an inflationary period on business and financial markets, it’s crucial to keep in mind that there are both positive and negative effects,” said Donald N. Hoffman, partner at Eisner Advisory Group and president of The Prosperity Consulting Group. “Some businesses might benefit from increased pricing influence, while others may struggle with rising costs. Likewise, markets can benefit and respond differently to inflation.”
Anyone who survived 2022 knows that inflation can be harmful, but it also has its economic benefits. Here’s a look at both sides of the coin, which won’t be able to buy as much next year thanks to inflation.
‘Good’ Inflation Comes From High Demand, Not Expensive Supplies
Three different economic scenarios contribute to the dollar-diminishing, price-hiking force of inflation:
Demand-pull inflation: When demand for a good or service exceeds supply, sellers can command higher prices.
Cost (or supply)-push inflation: When the costs of raw materials and production rise, businesses must raise prices whether demand increases or not.
Built-in inflation: When prices rise due to demand-pull or cost-push inflation, businesses have to pay their workers more or risk a labor shortage, forcing them to raise prices to keep up with higher payroll costs.
While all three scenarios lead to higher prices, only one can spur economic growth.
“Inflation is determined by both aggregate supply and aggregate demand,” said Dr. Tenpao Lee, a Fulbright scholar and professor emeritus of economics at Niagara University. “An increase of aggregate demand would cause inflation and higher GDP while a decrease of aggregate supply would also cause inflation but lower GDP. Therefore, demand-pull inflation is better than supply, or cost-push inflation. For example, quantitative easing would create demand-pull inflation. An oil embargo would create supply-push inflation.”
Modest Inflation Is Good Because the Alternatives Are Bad
No one likes to pay more for things today than they did last year. But stagnant or falling prices can signal economic weakness and inadequate demand, usually because of low consumer confidence and/or high unemployment.
“While low rates of inflation (1% or lower) or even deflation (falling prices) may seem desirable at first glance, sluggish growth in prices generally coincides with struggling economies and painful recessions,” said Dr. Krieg Tidemann, assistant professor of economics at Niagara University. “Producers, unable to sell goods and services, are forced to either cut or marginally increase their prices. Consistent with these factors, central banks like the U.S. Federal Reserve Bank generally target a steady inflation rate of 2% to 3% price growth.”
As 2022 Reminded Us, Excessive Inflation Is Destructive
While modest inflation is a byproduct of a growing economy responding to steady demand and rising wages, it’s unhealthy for prices to rise too much too quickly.
“Unstable or high rates of inflation above 4% to 5% have pernicious effects on both households and the economy at large,” said Tidemann. “During inflationary periods, the economy may experience lower rates of business investment or new residential construction. While this is at least partially due to the accompanying policy response of central banks raising interest rates, high or unstable inflation makes it difficult for businesses to make accurate predictions necessary for future planning. It may be challenging to determine future demand for their products or the return on any investment they make in new capital or buildings.”
Inflation’s Impact on Long-Term Assets Can Encourage Economic Growth
Anyone who bought a house for $21,000 in 1965 that they sold decades later for six figures understands how inflation can be a good thing — and that dynamic doesn’t apply only to individuals.
“Inflation benefits the broader economy in that it increases the prices of assets,” said Frank Corva, a personal finance expert with Finder.com. “Everyone from property owners to those with a retirement account to those who hold Bitcoin benefit from inflation in the long-term.”
When the hypothetical homeowners sell their inflation-appreciated home for a profit, they have more money to buy products and services, which spurs economic growth.
Reduced Purchasing Power Can Stifle Economic Expansion
While inflation can benefit buy-and-hold investors and encourage long-term asset growth, its corrosive effect on short-term purchasing power can constrict economic productivity.
“On balance, inflation tends to be bad for the economy because of all of the adverse dominoes that fall when inflation spikes, and that winds up leading to a slowdown in economic growth,” said Marbue Brown, founder of The Customer Obsession Advantage and author of “Blueprint for Customer Obsession.”
Brown used the housing market to illustrate a negative chain of events that is typical of inflationary periods:
The Fed raises interest rates to combat inflation.
Home loans become more expensive.
Sales of new and existing homes slow down.
New housing starts to decline.
Fewer sellers and buyers take on home remodeling projects.
Construction firms hire fewer employees or conduct layoffs.
Fewer families purchase big-ticket items like major appliances and furniture, leading to reduced production and layoffs in those industries.
The housing sector is just one example. A similar narrative could play out in the service industry, auto industry or any other corner of the economy during inflationary periods.
Inflation Makes Debt Cheaper for Households and Governments
One benefit of inflation is that it corrodes the value of debt. If you take out a loan at a fixed rate, inflation lets you pay it back later with dollars that are less valuable than the ones you borrowed.
This means your mortgage technically gets less expensive over time even though your monthly payments remain the same. The impact is much greater for the government’s massive borrowing obligations.
“It means it can pay off its debt with money that has less purchasing power than when it originally borrowed it,” said Baruch Silvermann, CEO of The Smart Investor. “When the government has less debt, it has to pay less interest on what it owes. This frees up more money that can be used for important things like building infrastructure, improving education, healthcare, or social welfare programs. This extra investment can boost the economy and lead to growth and development. Additionally, lower default risk makes government bonds more appealing to investors. This results in lower interest rates on government debt, which benefits both the government and borrowers all across the economy.”
Inflation Can Make Governments More Expensive To Manage
While inflation can make the government’s debt less expensive and easier to manage, it can also increase the cost of its day-to-day functionality.
“Rising interest rates due to high inflation hold implications for government spending and budgets,” said Tidemann. “While borrowing to cover deficits may not be as costly when interest rates are low, rising interest rates obviously increase the debt servicing share of government budgets. This can force governments into making tough decisions over what programs to finance or where cuts may need to be made. This is in addition to the rising cost of government production of services and goods due to higher inflation.”
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This article originally appeared on GOBankingRates.com: Can Inflation Be Good for the Economy? 3 Ways It Is and 3 Ways It Isn’t