5.1: The Ripple Effect of Inflation

Inflation is often understood as a rise in prices, but its deeper impact lies in how it distorts economic behavior and financial decision-making. Even moderate inflation can shift the incentives for spending, saving, and wage negotiation, making it a critical factor in economic stability and personal financial planning.

Erosion of Purchasing Power and Real Returns

As inflation progresses, the real value of money declines. This means consumers need more currency to purchase the same goods and services. While wage increases may occur over time, they often lag behind price rises, creating a gap in real income. This disproportionately affects individuals on fixed incomes or with static nominal earnings. If these incomes are not indexed to inflation, such as through cost-of-living adjustments, real purchasing power steadily deteriorates.

Savings also suffer. The real interest rate, calculated as the nominal interest rate minus the inflation rate, determines the actual gain from saving. When inflation outpaces interest earnings, the real return turns negative, disincentivizing long-term saving and encouraging short-term consumption or investment in inflation-resistant assets, such as real estate or commodities.

Business Costs and the Wage-Price Spiral

Inflation affects firms by increasing the cost of inputs, such as raw materials and energy. To preserve profitability, businesses may pass these costs to consumers, triggering further price increases. At the same time, workers push for higher wages to maintain living standards. If wage hikes are granted and businesses respond with more price increases, this feedback loop—known as a wage-price spiral—can sustain inflation even when initial pressures subside.

Historically, episodes like the 1970s U.S. stagflation illustrated how unchecked wage-price spirals and inflation expectations can embed long-term economic challenges. Central banks, in response, often raise interest rates to curb demand and stabilize price levels, though at the risk of slowing economic growth.

Inflation may seem like just a general rise in prices, but its effects reach far deeper across the economy.

Take Alex, for example. Last year, ten dollars could buy him three cups of coffee; now, the same amount only gets him two. With the same amount of money, Alex can buy less—this reflects a decline in purchasing power.

People on fixed incomes, such as some retirees, are especially vulnerable. Their income stays the same, but the value of money falls—unless it’s indexed to inflation.

Inflation also eats into the real return on savings. When prices rise faster than interest rates, an individual's purchasing power shrinks, making it harder to preserve long-term wealth.

Businesses also face rising input costs, such as for raw materials. To maintain profit margins, they may raise prices, which can reduce demand. Meanwhile, workers may demand higher nominal wages to keep up with the rising cost of living. If businesses grant wage increases and raise prices to offset those higher labor costs, it can trigger a wage-price spiral, where wages and prices continuously drive each other up.

In short, inflation reshapes how people earn, spend, save, and operate businesses.