Inflation, Part 2
We previously learned about many of the causes of inflation and how high levels of inflation can damage the economy. In this lesson, we'll talk about how inflation impacts various groups, read Hazlitt's analysis of inflation, and learn about deflation.
Impact of Inflation
Even low levels of inflation can have a significant impact on the economy, but it has different effects on different groups.
Inflation hurts savers in particular because it reduces the value of the money they've saved. It's also damaging for people on a fixed income, such as retirees. A retiree who earns $2,000 a month from his or her retirement savings will continue to earn $2,000 a month, even if inflation decreases the value of that money. This means that the buying power of the retiree's fixed income will decrease over time.
Interestingly, inflation can at times have positive effects on certain groups. For instance, people who have borrowed money at fixed rates will benefit from increased inflation. If you have a $100,000 loan, but the value of $100,000 goes down by 10%, then it essentially becomes 10% easier to pay off that loan. Inflation can also help those who own tangible resources that increase in value, such as homes or land.
The Mirage of Inflation
From our discussion of inflation so far, you might assume that inflation is universally viewed as something to be avoided. But while no one advocates for hyperinflation, many economists and politicians believe moderate levels of inflation can benefit the economy, especially during a recession or depression. Proponents of inflation believe that it will lead to higher production in a nation by creating more demand (through the creation of additional "purchasing power"). In this Hazlitt reading, you'll learn more about why most of the supposed benefits of inflation are merely an illusion.
Read Chapter 22: "The Mirage of Inflation" in Economics in One Lesson. [This may be Chapter 23 in some newer editions.] When you've finished reading, click the button below to continue with the rest of the lesson.
Deflation
Before completing our discussion of inflation, we need to cover its opposite: deflation, or a decrease in the general level of prices. It has the opposite effect of inflation, increasing the value of money and decreasing the value of tangible assets like homes. Deflation can be just as damaging as inflation, if not more so. It is usually accompanied by increased unemployment. Worried about the future, consumers decrease their spending. This causes demand to fall, which reduces the need for labor and causes companies to go out of business.
Deflation often causes a downward spiral in the economy. Think about it: if you knew that the hundred dollars in your wallet could buy more products tomorrow than it could today, what would you do with it? You'd likely save it for as long as possible. This increased saving by consumers means less demand for products, which deflates prices even more.
As demand continues to fall, companies aren't able to sell all the products they make. So, they reduce the number of employees they have, or they go out of business entirely. These newly unemployed workers will find it hard to get new jobs, and they'll end up defaulting on any loans they have, whether mortgages, car loans, or credit cards. When this happens, the banks that made those loans will lose all that money.
Remember that banks make loans using the money of their depositors. As banks continue to report losses, individuals that have accounts at those banks will likely try to withdraw their money—they'll be afraid that the bank will collapse and that they'll lose all the money in their accounts. But remember that, due to fractional reserve banking, banks only keep a certain percentage of deposits in reserve. If banks don't have enough cash on hand to pay back everyone who wants to withdraw money, the bank will indeed collapse. These bank closings will then cause even more damage to the economy as depositors lose their savings, consumers continue to curtail their spending, and businesses reduce their workforce even more.
Deflation is, therefore, usually an early sign of economic trouble. Like high inflation, it can start a devastating chain reaction. The United States has created many measures to help prevent collapses like this, but nothing is foolproof. Just like the housing crisis of 2008 reverberated throughout the whole economy, it sometimes only takes a breakdown in one area of the economy to create a ripple effect that disrupts everything.
Review of Key Terms
deflation: a decrease in the general level of prices
Economic crashes have occurred throughout history. Some economists believe these crashes are a natural part of market economies. Others believe that governments can and should institute policies to prevent (or at least minimize) these economic failures. In the next segment of the course, we'll study many of the policies that governments enact in pursuit of this goal.