One of the Federal Reserve’s responsibilities is to reduce inflation. Inflation occurs when there are too many dollars chasing too few goods. The relative purchasing power of the dollar drops and suppliers respond by increasing their prices. Inflation mainly has a negative impact on the business environment except with companies that carry a lot of debt.
Inflation occurs because of a self-reinforcing cycle of rising prices. Workers in a company assume all prices are going to rise because of inflation, so they demand an increase in their salaries. Their employer then increases the price of its goods to keep up with costs. This causes companies that purchase these goods to increase their prices as well, raising the overall price level for all goods. This higher price level causes workers to expect more inflation and demand raises for the next year, thus continuing the cycle of rising prices.
Higher Menu Costs
Inflation on its own does not damage a company’s profitability. As long as a company can continue to raise its prices by the inflation rate, its earnings should stay the same. This constant change in prices can create additional expenses for businesses. Inflation forces a company to continually update its prices. If the company publishes menus or brochures for its customers, the company must continuously pay to edit and republish this information. This added cost is known as the menu cost of inflation.
For businesses to make a long-term investment, they require a stable price environment. This lets companies accurately predict the future earnings and losses for long-term projects. Inflation creates uncertainty in investing. As price levels fluctuate, it becomes difficult for a business to value a long-term investment. This uncertainty will spook companies into only investing in short-term projects, as there is too much pricing risk in the future. This is known as investment myopia and is another negative impact of inflation.
Decreasing Debt Values
Since inflation causes the value of the dollar to decrease, it will also decrease the value of fixed debt denominated in dollars. While companies can raise their prices because of inflation, lenders do not have this flexibility with debts. Each year, inflation will decrease the real value of a fixed debt. This is advantageous for companies that have a lot of debt, as inflation will make it less expensive to pay off their loans. Inflation is a disaster to companies that have made loans, especially banks.
- “Financial Planning: Process and Environment” Craig Lemoine, et al.; 2009
- Tutor2u: Costs and Effects of Inflation
David Rodeck has been writing professionally since 2011. He specializes in insurance, investment management and retirement planning for various websites. He graduated with a Bachelor of Science in economics from McGill University.