SECTION 3: HARMFUL EFFECTS OF INFLATION

Unit 7

Long Run Consequences of Inflation

Inflation has the following harmful consequences:

1. Higher interest rates.

Inflation leads to higher interest rates in the long run. Initially when the government increases the
money supply, the increased availability of money lowers interest rates. However, the higher equilibrium
prices and lower value of the money due to the increased money supply leads banks and other financial
institutions to raise rates in order to compensate for the loss of the purchasing power of their funds.
Higher long-term rates discourage business borrowing, which leads to less investment in capital goods
and technology.

2. Lower exports.

Higher prices of goods mean that other countries will find it less attractive to purchase our goods. This
will lead to a decline in exports and lower production and higher unemployment in our country.

3. Lower savings.

Inflation encourages consumption instead of saving. Higher prices induce people to purchase more
products now, before they become more expensive. They discourage people from saving, because
money saved for future use will have less value. Savings are needed to increase funds in the financial
markets. This allows businesses to borrow money for investments in capital goods and technology.
Increases in technology and capital goods create long-run economic growth. Inflation leads to increased
consumption, which discourages savings and slows down economic growth.
4. Mal-investments.

Inflation leads to mal-investments. When prices rise, the value of certain investments increases faster
than others. For example, prices of existing houses, land, gold, silver, other precious metals, and antiques
increase with higher rates of inflation. More money is invested in these assets than other, more-
productive assets during increasing inflation. However, these assets are existing assets, and investing in
these assets does not increase our nation’s wealth and does not increase employment. Instead of funds
flowing into ventures that produce additional wealth, it is invested in assets that do not add to the
country’s productive capacity. Investing in productive and new business ventures is risky, because of
fluctuating inflation. An investor who plans to invest $2 million in a new business expects a certain rate
of return. If inflation is, for example, 12%, then the rate of return must be at least this, lest the investor
lose real income. If the investor is concerned that (s)he cannot return at least 12% on the investment,
(s)he will not start the new business.

In addition, while existing property owners may enjoy the increase in the value of their assets, current
buyers of property suffer. Current buyers pay for inflated land, houses, and other commodities. Some
workers who could afford to purchase a house ten or fifteen years ago can no longer do so.

5. Inefficient government spending.

When the government finances its expenditures through the use of newly printed money, it acquires
these funds by simply collecting the profits the Federal Reserve System makes from the additionally
printed money. Experience shows that funds acquired for free are not as carefully and efficiently spent as
funds acquired through greater sacrifice. When the government acquires funds by raising taxes, there is
a certain degree of accountability. When the government acquires funds through newly printed money,
there is no accountability, until citizens become aware of the real cause of inflation.

6. Tax increases.

Higher prices lead to increases in taxes. Nominal (not real) incomes rise along with inflation and push
income earners into higher percentage tax brackets. Even though purchasing power does not increase, a
person pays a bigger chunk of her/his income to the government. Property taxes on houses, land, and
other real estate, increase, as well. If the government adjusts the brackets along with the rate of
inflation, then tax rates will stay the same; however, many times the government does not adjust the
brackets, or does not adjust them fully. This will then lead to higher tax rates.

Why Do Governments Create Inflation?

With all the disadvantages of inflation, why do governments (more specifically, central banks, or in the
United States, the Federal Reserve), continue to print money and cause inflation? There are several
explanations for this. Printing money gives governments free access to funds. The Federal Reserve prints
billions of dollars each year and passes this on to the general government which uses the money for its
various spending items. In addition, printing money can stimulate the economy in the short run because
an increase in the money supply lowers interest rates in the short run. In our age of instant gratification
many people (especially politicians, as elections occur frequently) value short run benefits over long
term ones.

Another advantage (for the government) of inflation is that inflation raises nominal wages and pushes
people into higher tax brackets if brackets are not fully indexed (see harmful effect 6 above). Higher taxes
means more tax revenue for the government (and people won’t blame politicians for the higher taxes if
they don’t understand the cause of inflation).

Finally, inflation is beneficial if you have borrowed money because borrowers get to pay back their loans
in deflated dollars. The biggest borrowers in most economies are governments, so governments have a
vested interest in continuing to cause inflation. The opposite is true for people that save (mostly private
citizens that save and people that try to build up a pension). Inflation causes a decrease in the value of
savings in the future and therefore harms many private citizens. Financial markets are also harmed (see
harmful effect 3 above) as a decrease in savings causes fewer funds to be available in the financial
markets (i.e. less money for research and development, business expansions, etc.).