Editing Inflation (section)

== Effects of inflation ==

=== General effect ===
[[File:Restaurant increasing prices by $1.00 due to inflation.jpg|thumb|upright=1.2|Restaurant increasing prices by $1.00 due to inflation]]

Inflation is the decrease in the purchasing power of a currency. That is, when the general level of prices rise, each monetary unit can buy fewer goods and services in aggregate. The effect of inflation differs on different sectors of the economy, with some sectors being adversely affected while others benefitting. For example, with inflation, those segments in society which own physical assets, such as property, stock etc., benefit from the price/value of their holdings going up, when those who seek to acquire them will need to pay more for them. Their ability to do so will depend on the degree to which their income is fixed. For example, increases in payments to workers and pensioners often lag behind inflation, and for some people income is fixed. Also, individuals or institutions with cash assets will experience a decline in the purchasing power of the cash. Increases in the price level (inflation) erode the real value of money (the functional currency) and other items with an underlying monetary nature.

Debtors who have debts with a fixed nominal rate of interest will see a reduction in the "real" interest rate as the inflation rate rises. The real interest on a loan is the nominal rate minus the inflation rate. The formula ''R = N-I'' approximates the correct answer as long as both the nominal interest rate and the inflation rate are small. The correct equation is ''r = n/i'' where ''r'', ''n'' and ''i'' are expressed as [[ratio]]s (e.g. 1.2 for +20%, 0.8 for −20%). As an example, when the inflation rate is 3%, a loan with a nominal interest rate of 5% would have a real interest rate of approximately 2% (in fact, it's 1.94%). Any unexpected increase in the inflation rate would decrease the real interest rate. Banks and other lenders adjust for this inflation risk either by including an inflation risk premium to fixed interest rate loans or lending at an adjustable rate.

=== Negative ===
[[File:NY near Times Square pizza shop inflation sign 2.jpg|thumb|New York City Pizza shop where prices were changed from the fixed sign price of "$0.99" to the new price of "$1.50". During periods of high and rising inflation, prices may rise faster than a fixed-price sign is able to accommodate.]]
High or unpredictable inflation rates are regarded as harmful to an overall economy. They add inefficiencies in the market and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services to focus on profit and losses from currency inflation.<ref name="Taylor" /> Uncertainty about the future purchasing power of money discourages investment and saving.<ref>{{cite journal | title=Personal Savings and Anticipated Inflation | journal=The Economic Journal | last=Bulkley | first=George | volume=91 | issue=361 |date=March 1981| pages=124–135 | doi=10.2307/2231702 | jstor=2231702}}</ref> Inflation hurts asset prices such as stock performance in the short-run, as it erodes non-energy corporates' profit margins and leads to central banks' policy tightening measures.<ref>{{Cite web |title=Stock Returns and Inflation Redux: An Explanation from Monetary Policy in Advanced and Emerging Markets |url=https://www.imf.org/en/Publications/WP/Issues/2021/08/20/Stock-Returns-and-Inflation-Redux-An-Explanation-from-Monetary-Policy-in-Advanced-and-463391 |access-date=2023-01-08 |website=IMF |language=en |archive-date=January 8, 2023 |archive-url=https://web.archive.org/web/20230108213505/https://www.imf.org/en/Publications/WP/Issues/2021/08/20/Stock-Returns-and-Inflation-Redux-An-Explanation-from-Monetary-Policy-in-Advanced-and-463391 |url-status=live }}</ref> Inflation can also impose hidden tax increases. For instance, inflated earnings push taxpayers into higher income tax rates unless the tax brackets are indexed to inflation.

With high inflation, purchasing power is redistributed from those on fixed nominal incomes, such as some pensioners whose pensions are not indexed to the price level, towards those with variable incomes whose earnings may better keep pace with the inflation.<ref name=Taylor/> This redistribution of purchasing power will also occur between international trading partners. Where fixed [[exchange rate]]s are imposed, higher inflation in one economy than another will cause the first economy's exports to become more expensive and affect the [[balance of trade]]. There can also be negative effects to trade from an increased instability in currency exchange prices caused by unpredictable inflation.

;[[Hoarding]]: People buy durable and/or non-perishable commodities and other goods as stores of wealth, to avoid the losses expected from the declining purchasing power of money, creating shortages of the hoarded goods.

;Social unrest and revolts: Inflation can lead to massive demonstrations and revolutions. For example, inflation and in particular [[food inflation]] is considered one of the main reasons that caused the 2010–2011 [[Tunisian revolution]]<ref>"Les Egyptiens souffrent aussi de l'accélération de l'inflation", Céline Jeancourt-Galignani{{snd}}La Tribune, February 10, 2011.</ref> and the [[2011 Egyptian revolution]],<ref name="tna">{{Cite news|url=http://www.thenewage.co.za/8894-1007-53-Egypt_protests_a_ticking_time_bomb_Analysts|title=Egypt protests a ticking time bomb: Analysts|author=AFP|publisher=The New Age|date=January 27, 2011|access-date=January 29, 2011|url-status=dead|archive-url=https://web.archive.org/web/20110209104208/http://www.thenewage.co.za/8894-1007-53-Egypt_protests_a_ticking_time_bomb_Analysts|archive-date=February 9, 2011|df=mdy-all}}</ref> according to many observers including [[Robert Zoellick]],<ref>"Les prix alimentaires proches de 'la cote d'alerte'" – Le Figaro, with AFP, February 20, 2011.</ref> president of the [[World Bank]]. Tunisian president [[Zine El Abidine Ben Ali]] was ousted, Egyptian President [[Hosni Mubarak]] was also ousted after only 18 days of demonstrations, and protests soon spread in many countries of North Africa and Middle East.

;[[Hyperinflation]]: If inflation becomes too high, it can cause people to severely curtail their use of the currency, leading to an acceleration in the inflation rate. High and accelerating inflation grossly interferes with the normal workings of the economy, hurting its ability to supply goods. Hyperinflation can lead people to abandon the use of the country's currency in favour of external currencies ([[dollarization]]), as has been reported to have occurred in [[North Korea]].<ref>{{Cite news |author=Hanke |first=Steve H. |date=July 2013 |title=North Korea: From Hyperinflation to Dollarization? |url=http://www.cato.org/publications/commentary/north-korea-hyperinflation-dollarization |website=Cato Institute |url-status=live |access-date=August 21, 2014 |archive-url=https://web.archive.org/web/20201226020043/https://www.cato.org/publications/commentary/north-korea-hyperinflation-dollarization |archive-date=December 26, 2020}}</ref>

;[[Corruption]]: Due to a high rise of inflation,<ref>{{cite web |title=Inflation worldwide – Statics & Facts |url=https://www.statista.com/topics/8378/inflation-worldwide/#topicOverview |website=Statista |publisher=Einar H. Dyvik |access-date=March 11, 2024}}</ref> it has been seen to affect unemployment levels around the world. From 2005 to 2019, it was found that the wellbeing costs of unemployment was 5 times higher than inflation. The trust between the central banks and individuals has become more limited. According to the Global Labor Organization (GLO),<ref>{{cite web |title= Organization |url=https://glabor.org/organization/ |website=Global Labor Organization |date=July 28, 2017 |access-date=March 11, 2024}}</ref> a global sample of 1.5 million observations during the 1999 and 2012 found a negative relationship of ECB unemployment between countries of Spain, Ireland, Greece, and Portugal a financial crisis.<ref>{{cite web |title=The societal costs of inflation and unemployment |last1=Popova |first1=Olga |last2=See |first2=Sarah Grace |last3=Nikolova |first3=Milena |last4=Otrachshenko |first4=Vladimir |date=2023 |url=https://www.econstor.eu/bitstream/10419/279442/1/GLO-DP-1341.pdf |website=Global Labor Organization |publisher=EconStor |access-date=March 11, 2024 |url-status=live |archive-url=https://web.archive.org/web/20240313051643/https://www.econstor.eu/bitstream/10419/279442/1/GLO-DP-1341.pdf |archive-date= Mar 13, 2024 }}</ref> Lack of trust is shown between the government and political institutions which potentially, this can create bias towards both sides as unemployment rate will still increase. If the rate goes on, predictions of the economic activity may decrease, and investments from around the world will soon slowdown creating an "economy crash" that can affect millions of peoples' living.<ref>{{cite web |last1=Claessens |first1=Stijin |last2=Kose |first2=M. Ayhan |title=Recession: When Bad Times Prevail |url=https://www.imf.org/en/Publications/fandd/issues/Series/Back-to-Basics/Recession#:~:text=The%20unemployment%20rate%20almost%20always,with%20turmoil%20in%20financial%20markets. |website=F&D |publisher=IMF  |access-date=March 11, 2024}}</ref>

;[[Allocative efficiency]]: A change in the supply or demand for a good will normally cause its [[relative price]] to change, signaling the buyers and sellers that they should re-allocate resources in response to the new market conditions. But when prices are constantly changing due to inflation, price changes due to genuine relative [[price signal]]s are difficult to distinguish from price changes due to general inflation, so agents are slow to respond to them. The result is a loss of [[economic efficiency|allocative efficiency]].

;[[Shoe leather cost]]: High inflation increases the opportunity cost of holding cash balances and can induce people to hold a greater portion of their assets in interest paying accounts. However, since cash is still needed to carry out transactions this means that more "trips to the bank" are necessary to make withdrawals, proverbially wearing out the "shoe leather" with each trip.

;[[Menu cost]]
[[File:Subway pizza inflation 2022 jeh.jpg|thumb|upright=1.2|Low-cost price adjustment]]
: With high inflation, firms must change their prices often to keep up with economy-wide changes. But often changing prices is itself a costly activity whether explicitly, as with the need to print new menus, or implicitly, as with the extra time and effort needed to change prices constantly.

;[[Inflation tax|Tax]]: Inflation serves as a hidden tax on currency holdings.<ref>{{Cite journal|last1=Cooley|first1=Thomas F.|last2=Hansen|first2=Gary D.|date=1989|title=The Inflation Tax in a Real Business Cycle Model|url=https://www.jstor.org/stable/1827929|journal=The American Economic Review|volume=79|issue=4|pages=733–748|jstor=1827929|issn=0002-8282|access-date=October 7, 2021|archive-date=October 8, 2021|archive-url=https://web.archive.org/web/20211008164402/https://www.jstor.org/stable/1827929|url-status=live}}</ref><ref>{{Cite web|title=Inflation: A Tax on Money Holdings|url=https://www.economics.utoronto.ca/jfloyd/modules/inft.html|access-date=2021-10-07|website=www.economics.utoronto.ca|archive-date=November 11, 2020|archive-url=https://web.archive.org/web/20201111215101/https://www.economics.utoronto.ca/jfloyd/modules/inft.html|url-status=live}}</ref>

=== Positive ===

;Labour-market adjustments: Nominal wages are [[Sticky (economics)|slow to adjust downward]]. This can lead to prolonged disequilibrium and high unemployment in the labor market. Since inflation allows real wages to fall even if nominal wages are kept constant, moderate inflation enables labor markets to reach equilibrium faster.<ref>{{cite journal |last1=Tobin |first1=James |date=1972 |title=Inflation and Unemployment |url=https://www.jstor.org/stable/1821468 |journal=American Economic Review |volume=62 |issue=1 |pages=1–18 |jstor=1821468 |access-date=2023-03-22}}</ref>

;Room to maneuver: The primary tools for controlling the money supply are the ability to set the [[discount window|discount rate]], the rate at which banks can borrow from the central bank, and [[open market operations]], which are the central bank's interventions into the bonds market with the aim of affecting the nominal interest rate. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the bank cannot cut these rates further (since negative nominal interest rates are impossible) to stimulate the economy{{snd}}this situation is known as a [[liquidity trap]].

;Mundell–Tobin effect: According to the Mundell–Tobin effect, an increase in inflation leads to an increase in capital investment, which leads to an increase in growth.<ref>{{Cite web |last=Edwards |first=Jeffrey A. |date=2006 |title=Politics, Inflation, and the Mundell–Tobin Effect |url=https://mpra.ub.uni-muenchen.de/36443/ |access-date=2022-06-09 |website=mpra.ub.uni-muenchen.de |language=en |archive-date=November 1, 2018 |archive-url=https://web.archive.org/web/20181101141711/https://mpra.ub.uni-muenchen.de/36443/ |url-status=live }}</ref> The [[Nobel Memorial Prize in Economic Sciences|Nobel]] laureate [[Robert Mundell]] noted that moderate inflation would induce savers to substitute lending for some money holding as a means to finance future spending. That substitution would cause market clearing real interest rates to fall.<ref>{{cite journal|last=Mundell|first=James|journal=Journal of Political Economy|volume=LXXI|year=1963|pages=280–283 |title=Inflation and Real Interest|issue=3|doi=10.1086/258771|s2cid=153733633}}</ref> The lower real rate of interest would induce more borrowing to finance investment. In a similar vein, Nobel laureate [[James Tobin]] noted that such inflation would cause businesses to substitute investment in [[physical capital]] (plant, equipment, and inventories) for money balances in their asset portfolios. That substitution would mean choosing the making of investments with lower rates of real return. (The rates of return are lower because the investments with higher rates of return were already being made before.)<ref>Tobin, J. ''Econometrica'', Vol. 33, (1965), pp. 671–684 "Money and Economic Growth"</ref> The two related effects are known as the [[Mundell–Tobin effect]]. Unless the economy is already overinvesting according to models of [[Economic growth|economic growth theory]], that extra investment resulting from the effect would be seen as positive.

;Instability with deflation:  Economist [[Sho-Chieh Tsiang|S.C. Tsiang]] noted that once substantial deflation is expected, two important effects will appear; both a result of money holding substituting for lending as a vehicle for saving.<ref>{{cite journal |last1=Tsiang |first1=S. C. |title=A Critical Note on the Optimum Supply of Money |journal=Journal of Money, Credit and Banking |date=1969 |volume=1 |issue=2 |pages=266–280 |doi=10.2307/1991274 |jstor=1991274 |url=https://ideas.repec.org/a/mcb/jmoncb/v1y1969i2p266-80.html |language=en |access-date=October 20, 2020 |archive-date=April 25, 2021 |archive-url=https://web.archive.org/web/20210425223335/https://ideas.repec.org/a/mcb/jmoncb/v1y1969i2p266-80.html |url-status=live |url-access=subscription }}</ref> The first was that continually falling prices and the resulting incentive to hoard money will cause instability resulting from the likely increasing fear, while money hoards grow in value, that the value of those hoards are at risk, as people realize that a movement to trade those money hoards for real goods and assets will quickly drive those prices up. Any movement to spend those hoards "once started would become a tremendous avalanche, which could rampage for a long time before it would spend itself."<ref>Tsiang, 1969 (p. 272).</ref> Thus, a regime of long-term deflation is likely to be interrupted by periodic spikes of rapid inflation and consequent real economic disruptions. The second effect noted by Tsiang is that when savers have substituted money holding for lending on financial markets, the role of those markets in channeling savings into investment is undermined. With nominal interest rates driven to zero, or near zero, from the competition with a high return money asset, there would be no price mechanism in whatever is left of those markets. With financial markets effectively euthanized, the remaining goods and physical asset prices would move in perverse directions. For example, an increased desire to save could not push interest rates further down (and thereby stimulate investment) but would instead cause additional money hoarding, driving consumer prices further down and making investment in consumer goods production thereby less attractive. Moderate inflation, once its expectation is incorporated into nominal interest rates, would give those interest rates room to go both up and down in response to shifting investment opportunities, or savers' preferences, and thus allow financial markets to function in a more normal fashion.

=== Cost-of-living allowance ===

{{See also|Cost of living}}

The real purchasing power of fixed payments is eroded by inflation unless they are inflation-adjusted to keep their real values constant. In many countries, employment contracts, pension benefits, and government entitlements (such as [[social security]]) are tied to a cost-of-living index, typically to the [[consumer price index]].<ref name="cola wars">{{cite web |url=http://www.govexec.com/dailyfed/0906/090806rp.htm |title=COLA Wars |date=September 8, 2006 |work=Government Executive |publisher=[[National Journal Group]] |access-date=September 23, 2008 |last=Flanagan |first=Tammy |archive-url=https://web.archive.org/web/20081005120234/http://www.govexec.com/dailyfed/0906/090806rp.htm |archive-date=October 5, 2008 |url-status=dead }}</ref> A ''cost-of-living adjustment'' (COLA) adjusts salaries based on changes in a cost-of-living index.<ref>{{Cite web |last=Kunkel |first=Sue |title=Cost-Of-Living Adjustment (COLA) |url=https://www.ssa.gov/oact/cola/colasummary.html |url-status=live |archive-url=https://web.archive.org/web/20211127155725/https://www.ssa.gov/OACT/COLA/colasummary.html |archive-date=November 27, 2021 |access-date=2018-05-15 |website=www.ssa.gov |language=en-us}}</ref> It does not control inflation, but rather seeks to mitigate the consequences of inflation for those on fixed incomes. Salaries are typically adjusted annually in low inflation economies. During hyperinflation they are adjusted more often.<ref name="cola wars" /> They may also be tied to a cost-of-living index that varies by geographic location if the employee moves.

Annual escalation clauses in employment contracts can specify retroactive or future percentage increases in worker pay which are not tied to any index. These negotiated increases in pay are colloquially referred to as cost-of-living adjustments ("COLAs") or cost-of-living increases because of their similarity to increases tied to externally determined indexes.