Inflation Part II

The Impact of Inflation Effect 1: Decreasing Value of the Dollar With inflation, today’s dollar buys less than last year’s. Inflation decreases your purchasing power. Ex: Milk per glass $.50. With $1, you can buy two glasses of milk. With inflation, milk now costs $1 per glass. You can only buy one glass. Your purchasing power just went down. People that have fixed incomes, incomes that do not rise each year, are especially vulnerable to the decreasing value of the dollar through inflation.

Inflation can help borrowers Inflation can help borrowers. Those who borrow at a fixed rate of interest can repay their debts with dollars that are worth less, making their repayments smaller then they would have been without inflation. You want to buy a new house. You take out a 30 year fixed mortgage at 5%. You will have the same mortgage payment each month no matter what. Same price in 2010 and in 2025.

Effect 2: Increasing Interest Rates As prices increase, interest rates also tend to increase. Lenders raise their interest rates to ensure the earn money on their loans despite inflation. Higher interest rates mean that borrowing money becomes more expensive. When interest rates are high, businesses are less likely to borrow money to expand. When rates are higher, consumers are less likely to make purchases of high-priced items that they would need to finance.

Effect 3: Decreasing Real Returns on Savings Inflation can have a significant effect on savings. People who save at a low fixed interest rate will get you a lower return on their savings because of inflation. Ex: Put $100 in a savings account that pays 5% interest they will have $105 @ end of the year. But if the rate of inflation for the year was 10%, that $105 will buy be worth less. Although they will have more dollars, that money will buy less. Inflation can discourage savings.