Inflation : Impact on Economy
Understanding inflation is crucial to investing because inflation can reduce the value of investment returns. Inflation affects all aspects of the economy, from consumer spending, business investment and employment rates, to government programs, tax policies, and interest rates.
What is Inflation?
Inflation is a sustained rise in overall price levels. Moderate inflation is associated with economic growth, while high inflation can signal an overheated economy.
What Causes Inflation?
Economists do not always agree on what spurs inflation at any given time. However, certain forces clearly contribute to inflation.
- Rising commodity prices are perhaps the most visible inflationary force because when commodities rise in price, the costs of basic goods and services generally increase.
- Higher oil prices, in particular, can have the most pervasive impact on an economy. This, in turn, means that the prices of all goods and services that are transported to their markets by truck, rail or ship will also rise.
- Exchange rate movements can presage inflation. As a country’s currency depreciates, it becomes more expensive to purchase imported goods, which puts upward pressure on prices overall.
- Over the long term, currencies of countries with higher inflation rates tend to depreciate relative to those with lower rates. Because inflation erodes the value of investment returns over time, investors may shift their money to markets with lower inflation rates.
How Can Inflation Be Controlled?
Central banks, attempt to control inflation by regulating the pace of economic activity. Management of the money supply by central banks in their home regions is known as monetary policy. Raising and lowering interest rates is the most common way of implementing monetary policy.
- Lowering short-term rates encourages banks to borrow from the central banks and from each other, effectively increasing the money supply within the economy. Banks, in turn, make more loans to businesses and consumers, which stimulates spending and overall economic activity. As economic growth picks up, inflation generally increases. Raising short-term rates has the opposite effect: it discourages borrowing, decreases the money supply, dampens economic activity and subdues inflation.
- Central banks can also tighten or relax banks’ reserve requirements. Banks must hold a percentage of their deposits with the central banks as cash on hand. Raising the reserve requirements restricts banks’ lending capacity, thus slowing economic activity, while easing reserve requirements generally stimulates economic activity.
- The federal government at times will attempt to fight inflation through fiscal policy. The government can attempt to fight inflation by raising taxes or reducing spending, thereby putting a damper on economic activity; conversely, it can combat deflation with tax cuts and increased spending designed to stimulate economic activity.
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