Inflation destroys business confidence—companies unable to anticipate wages and profits, causing economic erosion

The inverse of the causes noted above can also place downward, or deflationary, pressure on prices. Cheaper inputs, negative inflation expectations, and decreased demand for goods and services — especially during an economic recession — can all lead to a decline in prices.

The various drivers of inflation can also influence how long inflation persists. For example, an oil shock or a . On the other hand, sustained periods of increased government spending or excessive printing of money can lead to longer periods with high inflation and potentially hard-to-control “spirals” where price increases feed subsequent price increases.

HOW DOES INFLATION AFFECT BUSINESSES AND CONSUMERS?

The rate at which prices change can have ramifications across the economy, affecting businesses and consumers alike. For instance, when high levels of inflation occur, the value of one’s money (also known as purchasing power) erodes, as consumers are no longer able to buy as much product with the same amount of money. Likewise, if wages do not rise at a similar rate as prices, inflation can devalue people’s wages and savings and increase the cost of living.

Changing prices can also create disparities across the economy by distorting the purchasing power for some individuals over time. An example of this is inflation’s effect on fixed interest payments. For instance, an individual with a fixed 3 percent yearly increase to their pension would lose purchasing power if inflation were higher than 3 percent, as the value of their pension would decline. On the other hand, someone with a fixed-rate mortgage of 3 percent would benefit from higher inflation as making those payments would become easier (assuming wages also rose with inflation).

Finally, inflation and deflation make it harder to anticipate how other aspects of the economy may change — such as interest rates, wages, taxes, and profits. That uncertainty could lead to less activity in the economy, such as businesses adjusting hiring decisions or households reducing their spending, and ultimately stunt economic growth.

WHAT ARE SOME OPTIONS FOR ADDRESSING INFLATION?

The Federal Reserve can attempt to contain inflation through a number of monetary policy tools. To avoid the negative effects that rapidly changing prices can have on the economy, the central bank generally tries to maintain stability by keeping inflation (measured through the PCE Price Index) contained to around a 2 percent annual increase. The Federal Reserve can utilize a number of . For example, they can influence how much banks lend to consumers and businesses by changing the , which is the interest rate banks pay on loans from the Federal Reserve; they can also alter the amount of money banks are required to keep on hand (known as ).

However, the most common method for the central bank to contain inflation is the  — the interest rate that banks charge one another for overnight borrowing. The federal funds rate influences other interest rates that affect the borrowing costs for businesses and consumers. Therefore, when inflation is too high, the Federal Reserve can  to make borrowing more expensive — decreasing the supply of money to lower inflation. On the other hand, if inflation is too low, the central bank can lower that rate to stimulate the economy and move inflation higher. However, the fluctuation of interest rates can have other economic consequences as well — affecting financial markets, indebted organizations, and .

CONCLUSION

The rate at which prices change can affect many facets of the economy — influencing people’s purchasing power, affecting economic growth, and raising or lowering interest costs on the national debt. Understanding and properly managing inflation is just one key element to promoting a .