Long Run Consequences of Inflation

The following are six harmful consequences of inflation. Inflation causes

1. Higher interest rates.

Inflation leads to higher interest rates in the long run. Initially when the government increases the money supply, the increased availability of money lowers interest rates. However, the higher equilibrium prices and lower value of the money due to the increased money supply leads banks and other financial institutions to raise rates in order to compensate for the loss of the purchasing power of their funds. Higher long-term rates discourage business borrowing, which leads to less investment in capital goods and technology.

2. Lower exports.
Higher prices of goods mean that other countries will find it less attractive to purchase our goods. This will lead to a decline in exports and lower production and higher unemployment in our country.

3. Lower savings.

Inflation encourages consumption instead of saving. Higher prices induce people to purchase more products now, before they become more expensive. They discourage people from saving, because money saved for future use will have less value. Savings are needed to increase funds in the financial markets. This allows businesses to borrow money for investments in capital goods and technology. Increases in technology and capital goods create long-run economic growth. Inflation leads to increased consumption, which discourages savings and slows down economic growth.

4. Mal-investments.
Inflation leads to mal-investments. When prices rise, the value of certain investments increases faster than others. For example, prices of existing houses, land, gold, silver, other precious metals, and antiques increase with higher rates of inflation. More money is invested in these assets than other, more-productive assets during increasing inflation.

However, these assets are existing assets, and investing in these assets does not increase our nation's wealth and does not increase employment. Instead of funds flowing into ventures that produce additional wealth, it is invested in assets that do not add to the country's productive capacity. Investing in productive and new business ventures is risky, because of fluctuating inflation. An investor who plans to invest $2 million in a new business expects a certain rate of return. If inflation is, for example, 12%, then the rate of return must be at least this, lest the investor lose real income. If the investor is concerned that (s)he cannot return at least 12% on the investment, (s)he will not start the new business.

In addition, while existing property owners may enjoy the increase in the value of their assets, current buyers of property suffer. Current buyers pay for inflated land, houses, and other commodities. Some workers who could afford to purchase a house ten or fifteen years ago can no longer do so.

5. Inefficient government spending.

When the government finances its expenditures through the use of newly printed money, it acquires these funds by simply collecting the profits the Federal Reserve System makes from the additionally printed money. Experience shows that funds acquired for free are not as carefully and efficiently spent as funds acquired through greater sacrifice. When the government acquires funds by raising taxes, there is a certain degree of accountability. When the government acquires funds through newly printed money, there is no accountability, until citizens become aware of the real cause of inflation.

6. Tax increases.

Higher prices lead to increases in taxes. Nominal (not real) incomes rise along with inflation and push income earners into higher percentage tax brackets. Even though purchasing power does not increase, a person pays a bigger chunk of her/his income to the government. Property taxes on houses, land, and other real estate, increase, as well. If the government adjusts the brackets along with the rate of inflation, then tax rates will stay the same; however, many times the government does not adjust the brackets, or does not adjust them fully. This will then lead to higher tax rates.