Costs and Benefits of Inflation

Inflation reduces the purchasing power of money and imposes costs on different groups. Unanticipated inflation erodes the real value of workers' wages, savers' deposits, and consumers' disposable income. Inflation is especially severe for people on fixed incomes, including those who rely on public assistance programs such as Temporary Assistance for Needy Families, a federal transfer program not indexed to the inflation rate. Uncertainty caused by unanticipated inflation also sours business investment in new capital, retards job creation, and dims prospects for economic growth. Figure 10.2 shows the impact of inflation on the value of the U.S. dollar from 1950 to 2010.[1] Note that the value of the U.S. dollar dropped in each decade. During the inflation-ridden 1970s the real value of the dollar dipped by more than 50 percent. The reference point for dollar values is the base year of 1982–1984, where the government established that $1 equaled $1.

Inflation also benefits some people. The main beneficiary of unanticipated inflation is debtors. Debtors benefit if they have taken out long-term loans that have a low fixed interest rate. In 2012 many banks offered 30-year fixed rate mortgages at historically low annual interest rates of about 4 percent. If inflation increases significantly in 2013 or thereafter these borrowers will benefit because they will repay their mortgage debt with cheaper, less valuable dollars in the future.

Deflation

Deflation, sometimes called negative inflation, occurs when the general price level in an economy decreases. Deflation is most often the result of insufficient aggregate demand in

Impact of Inflation on the Value of the U.S. Dollar

Figure 10.2 Impact of Inflation on the Value of the U.S. Dollar, 1950–2010

Source: U.S. Census Bureau, Statistical Abstract of the United States: 2012, “Table 724,” 473

an economy and is most likely to occur when large numbers of people are unemployed during a recession or depression. The United States suffered from severe deflation during the post–World War I economic downturn in 1921 (-10.5 percent) and 1922 (-6.1 percent), and during the early years of the Great Depression in 1931 (-9.0 percent), 1932 (-9.9 percent), and 1933 (-5.1 percent).[2] More recently many advanced economies around the world experienced a brief period of deflation during the global recession of 2007–2009. In 2009 deflation occurred in the United States (-0.3 percent), Ireland (-1.7 percent), Japan (-1.3 percent), Spain (-0.2 percent), Sweden (-0.5 percent), Switzerland (-0.5 percent), the Taiwan Province of China (-0.9 percent), and other countries.[3]

Deflation sends signals to producers and consumers that hinder economic growth. For instance, many businesses respond to deflation by reducing production, a predictable response to the expectation of lower prices for their output. Production cutbacks ripple through the economy, causing worker lay-offs and lower business investment. Deflation also discourages consumer spending on big-ticket items such as automobiles, consumer durables, and home renovations or repair. One reason for this drop in consumer spending is the specter of job loss during economic slowdowns. In addition, some consumers postpone major purchases with the expectation of still lower prices in the future. Persistent deflation in the Japanese economy during the 1990s and early 2000s stunted economic growth in the world's third largest economy.[4]

  • [1] U.S. Census Bureau, “Table 724: Purchasing Power of the Dollar, 1950 to 2010,” Statistical Abstract of the United States: 2012 (Washington, DC: U.S. Government Printing Office, 2011), 473.
  • [2] Ibid.
  • [3] IMF, “Table A6: Advanced Economies, Consumer Prices,” World Economic Outlook, April 2013 (Washington, DC: IMF, 2013), 157.
  • [4] World Bank, “Gross Domestic Product, 2012,” World Development Indicators (database), July 1, 2013
 
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