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What Are the Effects of Inflation?

A Look at the Effects of Inflation on the Economy

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What Are the Effects of Inflation?

What are the effects of inflation? The first is watching money become less valuable so that the purchasing power of each dollar, or pound sterling, or yen buys less goods than it did int he past. It is as if the purchasing power went up in smoke.

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The term "inflation" refers to rising prices of essentials such as wheat, milk, meat, clothing, medical services, coffee, electricity, etc. or, alternatively, the decline in value of money so that it takes more dollars to buy the same goods and services. A high inflation rate is anything over the 3% to 4% annual range, which is considered benign. But, as a new investor, what are the specific effects of inflation? Why should you be concerned about its spectre haunting the economy?

Inflation Begins with Money Losing Value

To understand the effects of inflation, I want you to think about a few numbers:

  • A $1.00 bill in 1971 had the same purchasing power as $5.24 does today. That is, what we call $1.00 would only buy 18¢ worth of goods in 1971.
  • A £1.00 bill in 1971 had the same purchasing power as £10.60 does today. That is, what we call £1.00 today would only buy £0.09 worth of goods in 1971.

As you can see, the major effect of inflation is that a nation's nominal currency loses value. That is, it takes more Dollars, or Pounds Sterling, or Euros, or Yen, or Swiss Francs, to buy the same quantity of goods.

Inflation Transfers Money from Savers and Investors to Debtors

If you follow the implications of this, you come to realize there are two other major effects of inflation.

  1. The effect of inflation on savers and investors is that they lose purchasing power. Whether you've buried your money in a coffee can in the back yard or it is sitting in the safest bank in the world, it is becoming less valuable with the passage of time.
  2. The effect of inflation on debtors is positive because debotrs can pay their debts with money that is less valuable. If you owed $100,000 at 5% interest, but inflation suddenly spiked to 20% per year, you are effectively watching 15% of your debt get paid off each year, totally free to you. At some point, you'd be able to get a minimum wage job at McDonald's for $100 per hour and just obliterate your debt.

The net effect of inflation is that it serves to transfer money from savers and investors to debtors. It punishes those who postpone their enjoyment and invested in building roads, schools, factories, and businesses and gives their reward to those who are in debt. It is a severe moral injustice, mostly caused by governments printing money to cover expenses that cannot be paid out of the general treasury revenue.

Another major effect of inflation is the damage it can do to the pocketbooks of average workers. Wages and salaries can lag cost of living increases, making families struggle to keep up as the price of everything form cornflakes to tuition increases faster than the take-home pay they receive from employers.

More Information About Inflation and the Inflation Rate

To learn more, read The New Investor's Guide to Inflation and the Inflation Rate, a special that answers questions such as:

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