When prices rise for energy, food, commodities, and other goods and services, the entire economy is affected. Rising prices, known as inflation, impact the cost of living, the cost of doing business, borrowing money, mortgages, corporate and government bond yields, and every other facet of the economy.
SEE: What You Should Know About Inflation.

Inflation can be both beneficial to economic recovery and, in some cases, negative. If inflation becomes too high the economy can suffer; conversely, if inflation is controlled and at reasonable levels, the economy may prosper. With controlled, lower inflation, employment increases, consumers have more money to buy goods and services, and the economy benefits and grows. However, the impact of inflation on economic recovery cannot be assessed with complete accuracy. Some background details will explain why the economic results of inflation will differ as the inflation rate varies.

Economic growth is measured in gross domestic product (GDP), or the total value of all goods and services produced. The percentage of growth or decline, compared to the previous year, is adjusted for inflation. Therefore, if growth was 5% and inflation was 2%, GDP would be reported at 3%.

As prices rise, the value of the dollar declines, as its purchasing power erodes with each increase in the price of basic goods and services.

The Cost of Borrowing
Low or no inflation, theoretically, may help an economy recover from a recession or a depression. With both inflation and interest rates low, the cost of borrowing money for investments or borrowing for the purchase of big ticket items, such as automobiles or securing a mortgage on a house or condo, is also low. These low rates are expected to encourage consumption, say some economists.

Banks and other lending institutions, however, may be reluctant to lend money to consumers when rates of return on loans are low, which decreases profit margins.

The U.S. Federal Reserve, which sets interest rates on government securities - mid- and long-term Treasury notes and shorter-term bills - has promised to keep rates at very low levels until 2014.

This assurance of low rates for the next two years is designed to stimulate the economy and keep inflation rates at a guaranteed level. The business community, including large, medium and small operations, know that certain fixed costs will remain constant, at least for that designated time period.

Businesses can therefore plan their borrowing, hiring, marketing, improvement and expansion strategies accordingly. Investors, likewise, know roughly what government and corporate bonds and other debt will return, since most of these instruments - if not so-called junk bonds - are pegged to Treasury yields.

However, economists differ notoriously in their opinions. Some economists claim that a 6% inflation rate for several years would help the economy by helping to resolve the U.S. debt problem, lifting wages and stimulating economic growth.

The Consumer Price Index
The standard measurement of inflation is the government's Consumer Price Index (CPI). Components of the CPI, a "basket" of certain elementary goods and services such as food - meat, vegetables and bread, for example - energy, clothing, housing, medical care, education, and communication and recreation. If the average price of all goods and services in the CPI were to go up 3% over the previous year's level, for example, then inflation would be pegged at 3%. This also means that the purchasing power of the dollar would have declined by 3%.

Hard assets, such as a home or real estate, often increase in value as the CPI rises; however, fixed income instruments - Treasuries or bank Certificate of Deposits, for example - lose value, because their yields don't increase with inflation. One notable exception, however, are treasury inflation protected securities (TIPS). Interest on these securities is paid twice yearly at a fixed rate as the principal increases in step with the CPI, thus protecting the investment against inflation.

The Bottom Line
Controlled inflation, no higher than 6% and perhaps somewhat lower, may have a beneficial impact on economic recovery, according to some economists, while inflation at 10% or above would have a negative impact. If the U.S. continues to increase its debt and continues to borrow money via Treasury issues, it may have to deliberately inflate its currency to eventually retire those obligations. Investors, retirees or anyone with fixed income investments will in effect be paying down those obligations, as their holdings decrease in value as prices rise.

SEE: The Importance Of Inflation And GDP.

Related Articles
  1. Mutual Funds & ETFs

    Top 3 Inflation Protected Bond Mutual Funds

    Learn about the characteristics and suitability of the top inflation-protected bond mutual funds, and how investors can use these funds to their advantage.
  2. Economics

    The Trajectory of Europe's Quantitative Easing Program

    The European Central Bank's quantitative easing program aims to save a heterogeneous Eurozone with liquidity for widespread investment.
  3. Investing

    Is it Time to “Buy” Inflation?

    Based on recent data from the Treasury-Inflation Protected Securities (TIPS) market, it would seem that most investors aren’t worried about inflation.
  4. Investing

    Which Economy Is Larger - The United States or China?

    China's economy may be larger than the U.S. economy, but it all depends on which exchange rate method you use to make the GDP comparisons.
  5. Economics

    How the Fed Fund Rate Hikes Affect the US Dollar

    Learn about the effects the federal funds rate on the U.S. dollar. Understand what happens when the Federal Reserve increases interest rates.
  6. Investing

    What is the Fiscal Year-End?

    It’s an important consideration for determining taxes, expenses and other financial matters.
  7. Economics

    10 Wealthiest States in the United States

    A review of the 10 richest states in America as ranked by median household income.
  8. Investing

    What a Fed Delay Means for the ECB & BoJ

    The Fed’s continued delay has repercussions for more than just the U.S. economy and markets. The ECB and the BoJ may support the case for stocks in Europe.
  9. Economics

    Understanding Income Inequality

    Income inequality refers to the uneven distribution of income across a single economy.
  10. Economics

    Who is a Hawk?

    In the economic sense of the word, a hawk is someone who believes high interest rates should be maintained to keep inflation low.
  1. Do lower interest rates increase investment spending?

    Lower Interest rates encourage additional investment spending, which gives the economy a boost in times of slow economic ... Read Full Answer >>
  2. Why are mutual funds subject to market risk?

    Like all securities, mutual funds are subject to market, or systematic, risk. This is because there is no way to predict ... Read Full Answer >>
  3. Who decides to print money in Russia?

    The Central Bank of the Russian Federation (CBRF), like its peers in most countries, is the governmental entity responsible ... Read Full Answer >>
  4. Who decides to print money in Canada?

    In Canada, new money comes from two places: the Bank of Canada (BOC) and chartered banks such as the Toronto Dominion Bank ... Read Full Answer >>
  5. Is Colombia an emerging market economy?

    Colombia meets the criteria of an emerging market economy. The South American country has a much lower gross domestic product, ... Read Full Answer >>
  6. Is Mexico an emerging market economy?

    Mexico meets all the criteria of an emerging market economy. The country's gross domestic product, or GDP, per capita beats ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Ex Works (EXW)

    An international trade term requiring the seller to make goods ready for pickup at his or her own place of business. All ...
  2. Letter of Intent - LOI

    A document outlining the terms of an agreement before it is finalized. LOIs are usually not legally binding in their entirety. ...
  3. Purchasing Power

    The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing ...
  4. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  5. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  6. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!