When is inflation good for the economy?

Inflation is and has been a highly debated phenomenon in economics. Even the use of the word “inflation” has different meanings in different contexts. Many economists, business people, and politicians maintain that moderate inflation levels are needed to drive consumption, assuming that higher levels of spending are crucial for economic growth.

The Federal Reserve typically targets an annual rate of inflation for the U.S., believing that a slowly increasing price level keeps businesses profitable and prevents consumers from waiting for lower prices before making purchases. There are some, in fact, who believe that the primary function of inflation is to prevent deflation.

Others argue that inflation is less important and even a net drag on the economy. Rising prices make it harder to save money, driving individuals to engage in riskier investment strategies to increase or even maintain their wealth. Some claim that inflation benefits some businesses or individuals at the expense of others.

Inflation is often used to describe the impact of rising oil or food prices on the economy. For example, if the price of oil goes from $75 a barrel to $100 a barrel, input prices for businesses will increase and transportation costs for everyone will also increase. This may cause many other prices to rise in response.

However, most economists consider the actual definition of inflation to be slightly different. Inflation is a function of the supply and demand for money, meaning that producing relatively more dollars causes each dollar to become less valuable, forcing the general price level to rise.

The primary impact of inflation is decreasing purchasing power. Although the denomination of currency doesn’t change, the impact of inflation is that the same amount of currency can buy less across inflationary periods. Though individuals may receive the cost of living adjustments to wages they take home, they more commonly see repercussions in the groceries they buy, the rent they pay, and transactions they incur.

As a result of higher inflation, the Federal Reserve often enacts monetary policy leading to higher federal funds rates. Higher federal funds rates have a domino effect to many other forms of lending and cause the cost of debt to be higher. Higher federal funds rates often, and credit card rates.

Because of higher debt rates, a downstream effect of higher inflation is a slower economy. During inflationary periods, prices are higher, and it is more expensive to incur debt. For these two reasons, companies often sell fewer products and the economy slows. This may lead to diminished corporate profits, layoffs, and pressures on households.

The end result of this cycle of events is a potential recession. The Federal Reserve tries to balance stemming inflation and maintaining acceptable levels of unemployment. However, each of the two items often moves in opposite directions. Their policies often increase one and decrease the other. Though there are no guarantees on the downstream effects of monetary policy, the Federal Reserve often risks causing a recession when combatting inflation.

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