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The confusion over inflation

Why do people worry about inflation? What are the economic effects of inflation?

Key points

  • Unexpected inflation tends to hurt those whose money received—in terms of wages and interest payments—does not rise with inflation.
  • Inflation can help those who owe money that can be paid back in less valuable, inflated dollars.
  • Low rates of inflation have relatively little economic impact over the short term. Over the medium and the long term, however, even low rates of inflation can complicate future planning.
  • High rates of inflation can muddle price signals in the short term and prevent market forces from operating efficiently.

The confusion over inflation

Many economists oppose high inflation, but they tend to oppose it with less fervor than many non-economists.
Robert Shiller, one of 2013’s Nobel Prize winners in economics, carried out several surveys during the 1990s about attitudes toward inflation. One of his questions was “Do you agree that preventing high inflation is an important national priority, as important as preventing drug abuse or preventing deterioration in the quality of our schools?” Answers were on a scale of one to five, where one meant “fully agree” and five meant “completely disagree.”
Of the entire US population, 52% answered “fully agree” that preventing high inflation was a highly important national priority and just 4% answered “completely disagree.” However, among professional economists, only 18% answered “fully agree;” another 18% answered “completely disagree.”

The land of funny money

What are the economic problems caused by inflation, and why do economists often regard them with less concern than the general public? Let's start with a very short story: The Land of Funny Money.
One morning, everyone in the Land of Funny Money awakened to find that the monetary value of everything had increased by 20%. The change was completely unexpected. Every price in every store was 20% higher. Paychecks were 20% higher. Interest rates were 20% higher. The amount of money—everywhere from wallets to savings accounts—was 20% larger. This overnight inflation of prices made newspaper headlines everywhere in the Land of Funny Money. But the headlines quickly disappeared as people realized that, in terms of what they could actually buy with their incomes, this inflation had no economic impact. Everyone’s pay could still buy exactly the same set of goods as it did before. Everyone’s savings were still sufficient to buy exactly the same car, vacation, or retirement that they could have bought before. Equal levels of inflation in all wages and prices ended up not mattering much at all.
When the people in Robert Shiller’s surveys explained their concern about inflation, one typical reason for their worry was that they feared that as prices rose, they would not be able to afford to buy as much. In other words, people were worried because they did not live in a place like the Land of Funny Money, where all prices and wages rose simultaneously. Instead, people live here on Earth, where prices might rise while wages do not rise at all, or where wages rise more slowly than prices.
Economists note that over most periods, the inflation level in prices is roughly similar to the inflation level in wages, so they reason that, on average over time, people’s economic status is not greatly changed by inflation. If all prices, wages, and interest rates adjusted automatically and immediately with inflation, as in the Land of Funny Money, then no one’s purchasing power, profits, or real loan payments would change. However, if other economic variables do not move exactly in sync with inflation, or if they adjust for inflation only after a time lag, then inflation can cause three types of problems: unintended redistributions of purchasing power, blurred price signals, and difficulties in long-term planning.

Unintended redistributions of purchasing power

Inflation can cause redistributions of purchasing power that hurt some and help others. People who are hurt by inflation include those who are holding a lot of cash, whether it is in a safe deposit box or in a cardboard box under the bed. When inflation happens, the buying power of cash is diminished. But cash is only an example of a more general problem: anyone who has financial assets invested in a way that the nominal return does not keep up with inflation will tend to suffer from inflation. For example, if a person has money in a bank account that pays 4% interest, but inflation rises to 5%, then the real rate of return for the money invested in that bank account is negative 1%.
The problem of a good-looking nominal interest rate being transformed into an ugly-looking real interest rate can be worsened by taxes. The US income tax is charged on the nominal interest received in dollar terms, without an adjustment for inflation. So, a person who invests $10,000 and receives a 5% nominal rate of interest is taxed on the $500 received—no matter whether the inflation rate is 0%, 5%, or 10%. If inflation is 0%, then the real interest rate is 5% and all $500 is a gain in buying power. But if inflation is 5%, then the real interest rate is zero and the person had no real gain—but they owe income tax on the nominal gain anyway. If inflation is 10%, then the real interest rate is negative 5%, and the person is actually falling behind in buying power. But, they would still owe taxes on the $500 in nominal gains.
Inflation can cause unintended redistributions for wage earners, too. Wages do typically creep up with inflation over time—eventually. However, increases in wages may lag behind inflation for a year or two since wage adjustments are often somewhat sticky and occur only once or twice a year. Also, the extent to which wages keep up with inflation creates insecurity for workers and may involve painful, prolonged conflicts between employers and employees. If the minimum wage is adjusted for inflation only infrequently, minimum wage workers are losing purchasing power from their nominal wages, as shown in the graph below.
US minimum wage and inflation
Image credit: Figure 1 in "The Confusion Over Inflation " by OpenStaxCollege, CC BY 4.0
One sizable group of people has often received a large share of their income in a form that does not increase over time—retirees who receive a private company pension. Most pensions have traditionally been set as a fixed nominal dollar amount per year at retirement. For this reason, pensions are called defined-benefits plans. Even if inflation is low, the combination of inflation and a fixed income can create a substantial problem over time. A person who retires on a fixed income at age 65 will find that losing just 1% to 2% of buying power per year to inflation compounds to a considerable loss of buying power after a decade or two.
Fortunately, pensions and other defined benefits retirement plans are increasingly rare, replaced instead by “defined contribution” plans, such as 401(k)s and 403(b)s. In these plans, the employer contributes a fixed amount to the worker’s retirement account on a regular basis, usually every pay check. The employee often contributes as well. The worker invests these funds in a wide range of investment vehicles. These plans are tax deferred, and they are portable so that if the individual takes a job with a different employer, their 401(k) comes with them. To the extent that the investments made generate real rates of return, retirees do not suffer from the inflation costs of traditional pensioners.
Ordinary people can sometimes benefit from the unintended redistributions of inflation as well. Consider someone who borrows $10,000 to buy a car at a fixed interest rate of 9%. If inflation is 3% at the time the loan is made, then the loan must be repaid at a real interest rate of 6%. But if inflation rises to 9%, then the real interest rate on the loan is zero. In this case, the borrower’s benefit from inflation is the lender’s loss. A borrower paying a fixed interest rate who benefits from inflation is just the flip side of an investor receiving a fixed interest rate who suffers from inflation. The lesson is that when interest rates are fixed, rises in the rate of inflation tend to penalize suppliers of financial capital, who end up being repaid in dollars that are worth less because of inflation. At the same time, demanders of financial capital end up better off because they can repay their loans in dollars that are worth less than originally expected.
The unintended redistributions of buying power caused by inflation may have a broader effect on society as well. The United States' widespread acceptance of market forces rests on a perception that people’s actions have a reasonable connection to market outcomes. When inflation causes a retiree who built up a pension or invested at a fixed interest rate to suffer while someone who borrowed at a fixed interest rate benefits from inflation, it is hard to believe that this outcome was deserved in any way. Similarly, when homeowners benefit from inflation because the price of their homes rises, while renters suffer because they are paying higher rent, it is hard to see any useful incentive effects. One of the reasons that inflation is so disliked by the general public is a sense that it makes economic rewards and penalties more arbitrary and therefore likely to be perceived as unfair—even dangerous..

Blurred price signals

Prices are the messengers in a market economy; they convey information about conditions of demand and supply. Inflation blurs those price messages. Inflation means that price signals are perceived more vaguely, like a radio program received with a lot of static. If the static becomes severe, it is hard to tell what is happening.
In Israel, when inflation accelerated to an annual rate of 500% in 1985, some stores stopped posting prices directly on items since they would have had to put new labels on the items or shelves every few days to reflect inflation. Instead, a shopper just took items from a shelf and went up to the checkout register to find out the price for that day. Obviously, this situation makes comparing prices and shopping for the best deal rather difficult.
When the levels and changes of prices become uncertain, businesses and individuals find it harder to react to economic signals. In a world where inflation is at a high rate, but bouncing up and down to some extent, does a higher price of a good mean that inflation has risen, or that supply of that good has decreased, or that demand for that good has increased? Should a buyer of the good take the higher prices as an economic hint to start substituting other products—or have the prices of the substitutes risen by an equal amount? Should a seller of the good take a higher price as a reason to increase production—or is the higher price only a sign of a general inflation due to which the prices of all inputs to production are rising as well? The true story will presumably become clear over time, but at a given moment, who can say?
High and variable inflation means that the incentives in the economy to adjust in response to changes in prices are weaker. Markets will adjust toward their equilibrium prices and quantities more erratically and slowly, and many individual markets will experience a greater chance of surpluses and shortages.

Problems of long-term planning

Inflation can make long-term planning difficult. In the section above on unintended redistributions, we discussed the case of someone trying to plan for retirement with a pension that is fixed in nominal terms during a period of a high inflation. Similar problems arise for all people trying to save for retirement because they must consider what their money will really buy several decades in the future when the rate of future inflation cannot be known with certainty.
Inflation, especially at moderate or high levels, poses substantial planning problems for businesses, too. A firm can make money from inflation—for example, by paying bills and wages as late as possible so that it can pay in inflated dollars, while collecting revenues as soon as possible. A firm can also suffer losses from inflation, as in the case of a retail business that gets stuck holding too much cash only to see the value of that cash eroded by inflation. But when a business spends its time focusing on how to profit by inflation, or at least how to avoid suffering from it, an inevitable tradeoff strikes: less time is spent on improving products and services or on figuring out how to make existing products and services more cheaply. An economy with high inflation rewards businesses that have found clever ways of profiting from inflation, which are not necessarily the businesses that excel at productivity, innovation, or quality of service.
In the short term, low or moderate levels of inflation may not pose an overwhelming difficulty for business planning because costs of doing business and sales revenues may rise at similar rates. If, however, inflation varies substantially over the short or medium term, then it may make sense for businesses to stick to shorter-term strategies. The evidence as to whether relatively low rates of inflation reduce productivity is controversial among economists. There is some evidence that if inflation can be held to moderate levels of less than 3% per year, it need not prevent a nation’s real economy from growing at a healthy pace.
For some countries that have experienced hyperinflation of several thousand percent per year, an annual inflation rate of 20–30% may feel basically the same as zero. However, several economists have pointed to the suggestive fact that when US inflation heated up in the early 1970s—to 10%—US growth in productivity slowed down, and when inflation slowed down in the 1980s, productivity edged up again not long thereafter, as shown in the graph below.
US inflation rate and US labor productivity, 1961–2014
Image credit: Figure 1 in "The Confusion Over Inflation " by OpenStaxCollege, CC BY 4.0

Any benefits of inflation?

Although the economic effects of inflation are primarily negative, two counterbalancing points are worth noting. First, the impact of inflation differs considerably according to whether it is creeping up slowly at 0% to 2% per year, galloping along at 10% to 20% per year, or racing to the point of hyperinflation at, say, 40% per month. Hyperinflation can rip an economy and a society apart. An annual inflation rate of 2%, 3%, or 4%, however, is a long way from a national crisis. Low inflation is also better than deflation which occurs with severe recessions.
Second, an argument is sometimes made that moderate inflation may help the economy by making wages in labor markets more flexible. A little inflation can nibble away at real wages, and thus help real wages to decline if necessary. In this way, even if a moderate or high rate of inflation may act as sand in the gears of the economy, perhaps a low rate of inflation serves as oil for the gears of the labor market. This argument is controversial. A full analysis would have to take all the effects of inflation into account. It does, however, offer another reason to believe that, all things considered, very low rates of inflation may not be especially harmful.


  • Unexpected inflation tends to hurt those whose money received—in terms of wages and interest payments—does not rise with inflation.
  • Inflation can help those who owe money that can be paid back in less valuable, inflated dollars.
  • Low rates of inflation have relatively little economic impact over the short term. Over the medium and the long term, however, even low rates of inflation can complicate future planning.
  • High rates of inflation can muddle price signals in the short term and prevent market forces from operating efficiently.

Self-check question

If inflation rises unexpectedly by 5%, would a state government that had recently borrowed money to pay for a new highway benefit or lose?

Review question

Identify several parties likely to be helped and several parties likely to be hurt by inflation.

Critical-thinking questions

  • If, over time, wages and salaries on average rise at least as fast as inflation, why do people worry about how inflation affects incomes?
  • Who in an economy is the big winner from inflation?

Want to join the conversation?

  • winston baby style avatar for user Oliver Daniels-Koch
    Does the government really benefit from increased tax returns, because wouldn't those returns be worth less?
    (7 votes)
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    • mr pink red style avatar for user Kelly Higgins
      Yes, they often do. Assume that in the "Land of Funnymoney" we had everything jump by 20%. Most developed nations have progressive tax rates split into increasing brackets. While the first part of your income will always be taxed at the lower rates of the bottom brackets, assuming the government does not adjust, or not sufficiently adjust, these brackets to correspond to that 20% bump in incomes and prices, than any additional income added on-top will be taxed immediately at the highest bracket you are marginally paying into, or possibly in the next higher percentage bracket. The government will have their impact from inflation covered by the bump in wages alone, the transition into the higher bracket for the tax payers could result in them paying 10% more in taxes on that new extra income, along with the fact that the government will possibly not adjust it's fixed income workforce adequately and may not adjust the qualifying level for government aid to the impoverished, they may reduce government outlay considerably. The middle-class and working poor can be hurt the worst by these inflationary jumps. Say you qualified for a needs-based scholarship to college if your mother only earned $24000 a year for your whole family to live off of. A 20% jump bumps her pay to $28,000 a year (but all eaten-up by price increases) and say at $28,800, you no longer qualify for the student aid, even though you're just as poor as ever.
      (9 votes)
  • leafers seedling style avatar for user Kaan Tarhan
    Who in an economy is the big winner from inflation really? There is no such thing right? It all fluctuates and one's loss is another's gain.
    (5 votes)
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    • male robot hal style avatar for user Enn
      This is a highly debatable topic.
      Some feel that a little inflation is good for an economy as it provides an incentive for producers to continue to expand production, resulting in growth of a nation's GDP.
      Additionally, it motivates people to not delay purchases unnecessarily as the price is continuously increasing.
      In deflation, people hold their purchases as they feel they can buy it later at a cheaper price. This fall of demand will cause a further fall of price.
      This can become a persistent problem and cause a deflationary spiral.
      (11 votes)
  • aqualine ultimate style avatar for user Gabrielle Pantano
    Could someone please explain the unintended redistributions of purchasing power concept in simpler terms if possible? It kind of confused me... feeling kind of dumb right now... Thanks!
    (3 votes)
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    • starky tree style avatar for user melanie
      Hi Gabby! I'm sorry you are feeling confused!
      Let's say I am planning a vacation in one year, and I see that flights to Barcelona are $550 each, so I figure I need $1100 for my friend and I to go to Spain. My other friend Eliza says she will pay me 10% interest if I loan her $1000, so I loan her $1000 thinking I will get paid back $1100 next year, and be able to afford my trip.

      But, after a year goes by the price of the airfare for both tickets goes up to $1250 due to inflation. My friend Eliza pays me back the $1100 as promised, but now I can't afford the flights. She paid 10% interest, but the prices increased by 25%, I *real*ly earned -15% interest! Inflation took away my purchasing power. On the other hand, Eliza is paying me back with money that isn't worth as much as it used to, so her purchasing power increased (in fact, maybe she used that money to go on vacation last year).

      In general, the easy way to think about this redistribution of purchasing power is that borrowers benefit from inflation (because they pay back with money that is worth less) and lenders lose (because they get paid back with money that is worth less).
      (12 votes)
  • leafers tree style avatar for user Matt Calcavecchia
    The self check question is challenging. The money borrowed is used to purchase the labor and materials for the road which are also subject to the 5% jump in inflation. How does the cost of the materials and labor balance with the benefit of higher value of money?
    (4 votes)
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    • starky tree style avatar for user melanie
      When there is inflation, money has a lower value, not a higher value. That means that a government is paying back with money that is worth less than it was when it was borrowed.

      The important aspect in this question is the distinction between nominal interest and real interest. When a bank charges someone interest, they think about how much interest they would like to earn, and then add some padding to take into account that there will be inflation (and, therefore, the bank will be paid back with money that is worth less than it is worth now). For example, if a bank really wants to earn 8% interest, and thinks the value of money will go down 2% (because there is 2% inflation), then they will charge 10% interest. That 10% is called nominal interest, the 8% real interest.
      (4 votes)
  • starky sapling style avatar for user Annie Hill
    so essentially, everyone is screwed by inflation except those who got rid of their money earlier
    (4 votes)
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  • blobby green style avatar for user Abigail  Vaughn
    With high expected inflation and low interest rate, you would rather be a borrower, can you explain?
    (2 votes)
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  • blobby green style avatar for user angusgillott
    "Low inflation is also better than deflation which occurs with severe recessions."

    Can this controversial line be explained rather than plainly asserted?
    (2 votes)
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    • hopper cool style avatar for user Iron Programming

      I agree with your skepticism. I do not see the benefits of inflation in an economy. Or at least, I should specify, the printing of money; which is the primary cause of inflation.

      For an example, even though it sounds all good for our presidents to be printing money and giving money to everyone all this is going to lead to is a recession or more likely a depression.

      From what I can tell, the presidents do this to make the people happy; but really from what I can tell from history the printing of money will eventually cause economic recessions and depression.

      A good book I'd recommend showing this is "Whatever happened to penny candy?". This book explains how the printing of money (which originated from the Romans clipping their coins) is not a good (wise) action.

      Anyway unfortunately many times people don't talk about the causes of the great depression and similar recessions. The whole point of studying history is to learn from our mistakes: how can we avoid another depression?

      Hope this helps.
      (4 votes)
  • piceratops ultimate style avatar for user Connor Griffith
    Theoretically wouldn't deflation potentially be better if it was accompanied by higher efficiency and production and allowed companies to produce more and lower costs, thus allowing them to lower prices and be more competitive in the open market?
    (3 votes)
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  • blobby green style avatar for user kestell
    In the land of funny money

    Interest rates were 20% higher.

    - this one seems to be incorrect. Or am I missing something?

    a 20% increase in interest rate is massive (especially when compounded), but a 20% increase in debt would have no impact.
    (2 votes)
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  • female robot grace style avatar for user Emily Ellwein
    What does "real wage" mean in the phrase, " A little inflation can nibble away at real wages, and thus help real wages to decline if necessary."?
    (1 vote)
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