Effects of inflation and the Portuguese case

  • Óscar Afonso
  • 8 February 2022

As Portugal is one of the most indebted economies in the world, it is too exposed to interest rate increases promoted by the ECB to control the path of the inflation rate.

Inflation is an economic concept that expresses the sustained increase in the price level of goods and services (typically of a representative basket) in a territory (usually in an Economy) and in a given period. Usually, the respective rate is measured based on the variation of the consumer price index. This, having underlying the basket of goods and services representative of the average consumption pattern, allows us to measure the amount consumers have to spend to maintain their standard of living, over time. Interestingly, inflation can either mean that the Economy is in trouble or it can be a sign of vitality. Here, I intend to describe thirteen potential effects of inflation.

  1.  It erodes the purchasing power of money. In other words, it decreases the amount of what can be bought with a given amount of money, thus reducing its purchasing power. In this sense, it tends to encourage economic agents to acquire alternative assets to money, which lose value more slowly.
  2. It encourages spending, saving and investment in the short run. One predictable response to the diminishing purchasing power of money is to anticipate purchases or to acquire assets that are immune to price changes. For consumers, this means bringing forward the purchase of goods with some durability, or saving and investing in financial assets or precious metals. For firms, it means making investments that, under different circumstances, could be postponed until later.
  3. Causes more inflation. Purchases and investments anticipated by inflation put pressure on their demand, so they fuel inflation, creating a feedback loop. That is, the supply of money outstrips demand, and its price – the purchasing power – falls. As economic agents spend more quickly in an attempt to reduce the detection time of money, in the limit, there can be hyperinflation phenomena.
  4. Penalizes confidence in the currency. Money plays a triple role: mean of exchange, unit of account, and store of value. These functions, and especially the first one, are only possible with confidence in money. What makes it possible to exchange “a piece of paper” for a good or service is the confidence that (that paper) will maintain its purchasing power. If money loses value considerably, economic agents no longer have confidence in it and it ceases to fulfil its functions.
  5. Increases the cost of borrowing, vis-à-vis independent central banks. Particularly since the 1980s, the framework for defining and implementing macroeconomic policies has changed. Governments have lost the instruments of money supply, which fortunately have passed to the responsibility of central banks. In turn, monetary policy has been constrained by binding rules to avoid excessive money supply. The need for monetary discipline was justified by the potential negative effects resulting from unwanted inflation. Central banks have at their disposal two main instruments that, in different ways, are based on changing the amount of money in circulation in economies. Wanting to decrease inflation, the first involves taking money out of the system by selling government bonds, but this has little effect in the long run. The second option is to raise the interest rate, which discourages credit and, therefore, consumption and investment, while encouraging savings. In this way, the circulation of money decreases, and its scarcity increases its value, although as a rule, central banks do not want money to become too valuable for fear of deflation. Rather, they should set the interest rate so as to keep inflation around a target rate (usually 2% in developed economies and 3% to 4% in emerging economies).
  6. Lower the cost of borrowing, in the face of central banks (weak because) colluding with politicians. When central banks let themselves be guided by politicians, as was the case until the 1980s, inflation lowered borrowing costs, but fortunately, this scenario is over! In this case, when household debt levels were significant, politicians found it electorally profitable to order the central bank to issue currency, buy government bonds, or to lower the interest rate, stoking inflation and temporarily driving bonds away from voters. When it was the government itself that was heavily in debt, politicians had an even more obvious incentive to issue currency and use it to pay off the debt, stoking inflation. It was politicians’ “self-interested taste” for inflation that convinced the best-run countries to hand over monetary policy to independent central banks.
  7. Reduces unemployment. Keynes theorized that the Great Depression resulted, in part, from the downward rigidity of wages. Unemployment rose because workers resisted the wage cuts and, consequently, were laid off. The same phenomenon can also work the other way around: upward wage rigidity means that when inflation reaches a certain rate, employers’ real wage costs fall and employers hire more workers. This hypothesis seems to explain the inverse correlation between unemployment and inflation – a relationship known as the Phillips curve –, but a more common explanation puts the onus on unemployment. As unemployment falls, employers are forced to pay more. Now, wage increases improve the purchasing power of consumers, stimulating inflation because the economy is “warmed up”.
  8. It increases economic growth, in the short run. Unless there is a central bank watching to raise interest rates, inflation discourages saving, as the purchasing power of deposits decreases over time. This prospect encourages consumers and businesses to spend or invest. In the short run, the boost to spending and investment generates economic activity and, thus, leads to economic growth. Similarly, the negative correlation of inflation with unemployment implies a tendency to put more people to work, stimulating growth.
  9. It reduces employment, competitiveness and economic growth, in the long run. The literature provides ample evidence that production requires liquidity because producers need money to make payments. Considering Cash-in-Advance (CIA) constraints on production in general and R&D investment in particular, a negative relationship emerges between inflation and the rate of economic growth, as CIA constraints under high-interest rates, imposed by central bank monetary policy, penalize production and thus the drivers of growth. Consequently, it discourages investment, competitiveness and job creation.
  10. Inflation favours inequality. The relationship between inflation and intra-country wage inequality depends on firms’ credit constraints and inflation levels; in particular, inflation increases intra-country wage inequality in favour of skilled workers. Moreover, when inflation increases in developing countries, it increases inter-country wage inequality in four of developed countries.
  11. It weakens the local currency. Significant inflation is usually associated with a weakened currency in the international context – i.e., it depreciates the exchange rate. Economies that import significant quantities of goods and services have to pay more for the imports in local currency terms, and the terms of trade deteriorate.
  12.  It strengthens the local currency in the face of independent central banks. But also at this level, inflation can strengthen the currency, depending on the context. Wishing to lower inflation, independent central banks raise the interest rate, thereby encouraging demand for domestic currency and thus helping to strengthen the currency.
  13. It penalizes social stability. In a climate of inflation, prices tend to change unpredictably, which can lead to considerable losses; for example, by reducing the value of savings. Usually, it is the most disadvantaged groups that are penalized the most.

In the context of full independence of the European Central Bank (ECB) and the excessive indebtedness that the Portuguese economy has reached, the current increase in the inflation rate should “wake up the elephant in the middle of the room”. As Portugal is one of the most indebted economies in the world (well above the average European Union), it is too exposed to interest rate increases promoted by the ECB to control the path of the inflation rate. This constitutes a barrier to investment as it makes credit granted to firms and citizens more expensive, penalizing economic growth and thus the standard of living of the Portuguese.

  • Óscar Afonso
  • President of OBEGEF and Professor at FEP - School of Economics and Management