The Effect of Inflation on Debt

The federal government regularly monitors the prices of consumer goods and services to calculate the rate of inflation monthly. This information is gathered from approximately 23,000 businesses and 50,000 landlords or renters around the nation to calculate a Consumer Price Index, or CPI. The resulting CPI is used to measure inflation. Increases and decreases in inflation influence all levels of the economy, including how we use both personal and public debt.

Inflation in simple terms refers to price increases. In everyday life, an increase in inflation can mean consumers pay more at the grocery store and the gas pump. Increased inflation also affects services. For example, as service providers such as hairstylists and dry cleaners feel the effects of inflation, they in turn must raise prices to cope, and the consumer pays more at the hair salon and cleaners.

Inflation has a direct effect on the purchasing power of consumers. Higher prices for goods and services as a direct result of inflation reduce what a dollar will buy today. Consequently, consumers may borrow more as a way to increase personal buying power for everyday needs, such as using a credit card to grocery shop, adding to personal debt.

Because financial institutions also feel the effects of inflation, interest rates on personal loans are increased to compensate for the reduced value of a dollar. These higher interest rates cause consumers to pay more in the long term for a loan, thus increasing the consumer's overall debt obligations. However, if inflation continues to rise, the borrowed dollar today will hold more value in purchasing power than the one repaid on the loan in the future.

During times of lower inflation, interest rates tend to be lower. Low levels of inflation can spur consumers to borrow for large purchases, such as a new automobile or a home. Debt obligations are lower over time because of the current increased purchasing power if interest rates on the loan remain steady.

The federal government may issue debt securities in times of higher inflation. Selling these securities to private individuals reduces the money supply in the economy and thus reduces the demand on other goods and services, with the goal being to force prices to fall. Although these measures may provide some relief to current consumers, taxpayers in the future will then be responsible for repaying this increased public debt. With less disposable income in the population, a reduction in economic activity may result, leading to a period of deflation. During times of deflation, less credit is readily available to consumers.