The Impact of Inflation on Purchasing Power

Inflation is like a hidden tax in the economy. Although it never appears on tax returns or income statements, everyone pays for inflation. It impacts the way our economy works and how people spend and corporations handle their business. For this reason, a deep understanding of economic indicators, like inflation, is critical for those who wish to excel as business leaders, including professionals specializing in finance.

What Is Inflation?

The International Monetary Fund defines inflation as how much more expensive goods and services have gotten over a set period (usually a year). Inflation is often viewed as an increase in the price of goods and services for the whole economy but can also decrease a currency’s purchasing power over time.

The best way to visualize inflation is via the Big Mac index. When McDonald’s first released the famous Big Mac in 1967, it cost just 45 cents. Today, that same sandwich costs over $4.00. Although nothing has inherently changed about the Big Mac, it costs significantly more today than it used to. This is inflation in action. You can better understand how inflation works by experimenting with a cost-of-living calculator.

The effects of inflation are similar to watching a weed grow. It’s nearly impossible to notice any significant change in real time. But, if you leave the weed alone for a year or so, it becomes clear just how much bigger the weed has gotten. The same is true for inflation.
In a healthy economy, the inflation rate is usually around 2-3%. However, in more severe scenarios, inflation can reach 10% or higher. At an inflation rate of 10%, savings accounts with $10,000 would only be worth $9,000 the following year in terms of purchasing power, presenting a major problem for consumers and producers alike.

Main Causes of Inflation

There is an expected level of inflation with most items, but several factors can accelerate inflation beyond the average rate:

  • An increase in the money supply: Government policies that increase the money supply can cause high inflation. In particular, the COVID-19 relief packages injected billions of dollars into the economy and contributed to price increases. Over time, this leads to a decrease in the purchasing power of each dollar.
  • Supply chain issues: When companies face tougher conditions to manufacture products, it restricts the supply of those products. In turn, a tighter supply of products relative to demand leads to increased consumer prices, which has an inflationary effect.
  • War and cost-push inflation: War is incredibly disruptive to the global economy. For example, the current war between Russia and Ukraine has prompted many other countries to institute sanctions against Russia. These sanctions limit the flow of key resources (such as gas or wheat) into the global economy and increase costs and prices.
  • Pandemic: Although the COVID-19 pandemic is waning in aggression and public attention, it still contributes to inflation. Mainly, the pandemic forced workers to stay home for months, reducing the number of goods companies could produce. Again, supply being lower than demand led to increased prices. Additionally, the pandemic made it difficult for producers to forecast demand accurately. This, in turn, inhibited their ability to manufacture goods efficiently.

Here’s a closer look at how high inflation impacts different economic stakeholders.

Inflation’s Impact on Consumers and Producers

When talking about inflation, the focus is usually on consumers, many of whom feel the impact of inflation on their daily spending. For example, a trip to the grocery store that used to cost $100 might now cost $140, or a tank of gas that used to cost $60 now costs over $100. On top of that, inflation has an erosional effect on savings.

Even in a healthy economy with inflation of 2%, a lump sum of savings will lose roughly half of its value in 36 years. You can determine this by using the rule of 72. However, during periods of higher inflation, savings accounts can lose value much more quickly. These are the two most significant ways inflation impacts consumers, but it’s important to note that producers are not immune to these effects.

Inflation leads to higher prices for raw materials, increasing a corporation’s costs, squeezing its margins and even forcing it out of business altogether. Of course, corporations facing rising inflation can always raise their prices to compensate for this cost increase. However, they must be sure not to raise prices too quickly or risk hurting demand for their products. Business leaders must balance maintaining bottom-line profitability while not alienating their existing customer base.

Business Leaders Leading the Way

The world has become increasingly globalized in recent years. Policies or actions of people on the other side of the world can directly impact your company and career. For this reason, having a deep understanding of economic concepts, such as inflation, can be crucial to your professional success.

Understanding the impact of inflation on purchasing power can better help you manage economic fluctuations and protect the interests of your employer. Therefore, many college students consider receiving a Master of Business Administration (MBA) that focuses on finance, such as the program offered by William Paterson University. These programs ​​will enhance your ability to think critically, use data to make informed decisions and improve your chances of success.

Learn more about William Paterson University’s online MBA with a concentration in Finance program.

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