Before assessing the effect of low inflation on a country’s economy, it’s important to define the term inflation.
What is inflation?
Inflation is a term commonly used to refer to the general increase in prices of goods and services. Inflation is measured as an annual % increase. As inflation increases, the purchasing power of every pound decreases. For example, if the inflation rate is 3%, then a £1 loaf of bread will cost £1.03 in one year.
Ideally, the price of goods and services is bound to increase over time. The rise should, however, be gradual otherwise, the economy will suffer. Let’s shift our focus to the effects of inflation on the economy for us to understand the effects of low inflation.
When prices of goods/services increase, the cost of living also increases. It also becomes more expensive to conduct business in a country with high inflation. The cost of borrowing increases. There is also a corresponding increase in corporate as well as government bond yields. As a result, inflation can have negative as well as positive effects.
If inflation is controlled i.e. kept at low or at reasonable levels, the economy of the country in question prospers. The opposite happens when inflation is too high. Low inflation boosts employment. When people are employed, they have more money to spend. When people are buying more goods and services, the economy grows.
The full impact of low inflation in regards to economic recovery can’t, however, be assessed with unmatched accuracy. To understand this in-depth, it’s important to assess the effects of low inflation on economic metrics such as; the GDP, cost of borrowing and the consumer price index.
Effects of low inflation on GDP
The GDP (Gross domestic product) of a country is simply the value of all goods/services produced by that country. GDP is expressed as a percentage and adjusted for inflation. For instance, if the growth was 8%, but the inflation was 3%, the GDP would be 5%. Low inflation is, therefore, good for the GDP or overall growth of the economy.
Effects of low inflation on cost of borrowing
Theoretically, low inflation can help a country’s economy to recover from depression or recession. The interest rates must, however, be low for this to happen. Low inflation and low interest rates decrease the cost of borrowing encouraging people to take loans and invest or spend. Low-interest rates may, however, make banks reluctant to issue loans since the returns on loans are equally low. A low inflation and low-interest rate environment may, therefore, have a negative effect on consumption.
Low interest rates over a prolonged period of time coupled with low inflation assure the business community of fixed costs. Business owners are able to plan better i.e. when to borrow, market, hiring as well as expand in low interest/low inflation environments. Investors are also in a better place to calculate returns on investments on corporate and government bonds. It’s, however, worth noting that that the effects of low inflation may vary in regards to borrowing.
Effects of low inflation on the consumer price index
Inflation is usually measured by considering the price of essential goods and services as opposed to all goods and services. Inflation focuses on consumables (in the consumer price index) like food prices as well as the price of clothing, housing, energy, education, medical care, communication, and recreation. If the price of all goods/services in the consumer price index increases by say 4%, the rate of inflation is pegged at 4% and the purchasing power decreases by 4%. Low inflation is good since it ensures the cost of essential goods and services remains stable.
Low inflation is beneficial to the economy on almost every level from the GDP to the cost of borrowing and price of essential goods and services. Low inflation is particularly beneficial to a struggling economy since it helps to keep a check on the price of essentials and also encourages people to borrow and spend. Low inflation must, however, be supplemented by low-interest rates for it to encourage borrowing and spending.