Previously, we have discussed about how any attempt to raise a nation’s wealth by printing money (or in fancy term, Quantitative Easing) would be futile without prior growth in production, both goods and services. The demand-pull inflation, the depreciation of currency value due to the delusion people hold (they feel richer) when having more money printed out of thin air, renders this approach ineffective. Is that all though? Nope. The repercussion does not stop here. I dare say that any reckless decision based on personal whim, rather than on well-studied reasons or systems, can incapacitate the whole economy, or at least, some sectors within it.
First, you must know that though an economy heavily depends on production of goods and services, the role of money as a medium of exchange is indispensable. We work to earn money. We then use it to purchase various goods and services as needed and desired. So what will happen if the $100 bill we hold suddenly depreciates in value? You know it, I know it, She knows it, Everyone knows it. When our money depreciates, we can purchase less goods and services just as mentioned in Part 1 of this article. In other words, inflation erodes our purchasing power. If our wage is not pegged to the CPI (Consumer Price Index, a metric measuring inflation about which I will probably explain more in my later article ), then we are in big trouble. Wage that is adjusted following the change in inflation rate can, to a certain degree, cushion the adverse effect of inflation. However, those living with fixed wage, ex: retirees depending on pension, will surely suffer as the real value of the pension paid to them is becoming lower and lower. This, in a way, is a means of stealing people’s money by the central bank or the government. By printing more money, making you feel richer, they are making your hard-earned cash worth less, turning you into a poorer being in real term.
That is not all. When inflation increases, the real interest rate you obtain from whatever amount of the loan you made will fall. Think of it this way. I will make it simple. Imagine you lend me $1000 with 10% interest. So with no inflation at all, the money you would get back is exactly $1100 in real term, a $100 profit. What if there is 50% inflation? Simply put, that means you are still getting $1100, but its real value is 50% less (because price of goods rise by 50%). So the actual amount you get from making this loan is actually ($1000+$100)*0.5 = $550. Well, you are losing $450 of the initial principal, the original sum lent of $1000.
Inflation can also affects people’s perception of the economy. When there is high inflation, people tend to save less (because the value of their money, if saved, will just get lower and lower) unless the bank offers high interest rate, at least, as much as the inflation rate. That means if the money is losing 20% of its value annually, the bank must be willing to offer 20% return (interest) of the amount deposited in order to attract customers. Plus, if the interest rate is fixed by the central bank, rising inflation will increase demand for loan accompanying with much lower supply of it. The problem is, just as in the previous example, people know for sure that if they borrow $1000 now and spend it, they can just pay back much less in real term in the future because inflation eats away the value of the $1000 and the interest they are obliged to return. However, people with surplus of money (saving) are not stupid. They know they will get less if they lend their money out to those opportunists. So the most rational decision is to spend the money now, buying as much goods as they can, investing in assets and commodities, which in turn, will worsen the effect of inflation, and shake the very foundation of the market. You might end up seeing precious metals price such as gold price jumping through the roof, but at the same time, there might be much less saving, thus less investment, a vital component of a country’s GDP.
While saving (which constitutes the supply of loan for new investments) shrinks, Inflation greatly discourages investors (the demand side of investment) as the expected return from their investment in existing or start-up business becomes less and less. For instance, if the expected return of the investment is 40%, but the current inflation rate is 50%, that means you will lose 10% if you decide to invest. So high inflation rates can significantly lower the propensity to invest within a country.
If we look at the foreign trade sector, we will know for sure that inflation is bad. Inflation will pose 2 major challenges for the global competitiveness of a country. First, inflation increases the price of goods and services within a country, and that means, at the start, domestically produced goods and services cost higher than the imported ones. People, consumers in general, will normally choose lower price products, so local businesses now have a hard time competing with those of the foreign ones who are not suffering from the inflation pressure (to raise price). This holds true to both the local and the global markets. Thus, domestic producers will be susceptible to bankruptcy, threatening higher unemployment rate and many other problems within that particular economy. When the demand for foreign goods increases and the demand for domestic goods decreases, what will happen is the depreciation of the domestic currency (i.e. the domestic money declines in value). Why? Think about the demand and supply. More demand for foreign products is equivalent to more demand in exchanging domestic currency to foreign currency to purchase those foreign goods. You know where this is going, right? More demand for foreign currency and less demand for domestic currency will eventually increase the value of foreign currency and lower the value of domestic currency. As the domestic currency depreciates, foreign investors will face a huge loss. It is almost as if they are getting ripped off. For example, you are a US investor. You invest in the Japanese market, and you earn 1,000,000 yens. At that time, 1 yen = $1 (of course, it is just an example). Since Yen has depreciated, now 1 yen = $0.5 (yes, just an example). So before the inflation took off, you can convert your return of 1,000,000 yens to dollars, and you would get exactly $1,000,000. Not bad. But now, since 1 yen = $0.5, your 1,000,000 JPY is reduced to only $500,000. You know what? You have just lost half of your return. As a result, it will certainly discourage you or any other investors to consider Japan as a potential target. Worst case scenario, Japan will be labelled as a country with high risk lower return for investment.
High inflation effect can be seen everywhere. Just for the fun of it, I will give you another example of how inflation might affect your business. If you own a restaurant, with high inflation, you must change your prices often to keep up with the rising prices in the economy. This is costly because you need to spend your time and energy doing it, and not to forget, you also need to probably print new menus!
Well, inflation seems to hurt, but economics is not a straight-forward social science. Economics confuses a lot of people because they tend to think of it from only a corner of view. Inflation, though seems hazardous, also have its positives. However, when we are talking about inflation, note in mind that there are different levels of inflation. Economists tend to favor a low and steady rate of inflation because they (and I) think that it is good for the health of an economy. In the next article, we will look beyond our pessimism, and explore the positive space of inflation.
Because when a cup is half empty, it is also half full.