When prices for energy, food, commodities, and other goods and services rise, 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.

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.

How Inflation Works

GDP

Economic growth is measured in gross domestic product (GDP), or the total value of all finished goods and services produced in a specific period. 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.

Key Takeaways

  • Inflation is the rise in the price of goods and services in an economy over a certain period.
  • Inflation that is controlled and low generally helps an economy recover from a recession and results in increases in employment.
  • The gross domestic product (GDP), which represents the total value of a nation's finished goods and services produced, measures the health of an economy.
  • The Consumer Price Index (CPI) measures an economy's inflation and includes "basket" of basic goods and services, such as food, energy, clothing, and housing.

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 according to 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. Businesses can 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 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 US 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 include a "basket" of certain elementary goods and services, such as food, 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 lose value because their yields don't increase with inflation. Treasury inflation-protected securities (TIPS) are a notable exception, however. 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.

Special Considerations

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 US 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.