Causes and Effects of Inflation on Your Business

What precisely does inflation mean for you and your company?

Inflation has effects other than merely making products more expensive. There are a number of effects of inflation that create problems for small businesses such as yours. It’s important for a small business owner to know the effects of inflation. This will help you protect yourself and your business during inflationary periods.

What Is Inflation?

Inflation is a blanket term used to refer to increased prices for goods and services. This is generally measured over quarters. When inflation is “in the red,” it is said to be “deflation.” The tangible result of deflation is a reduced cost of goods and services. “Core inflation” attempts to get at the heart of the inflation rate by excluding items such as food, which regularly suffer from erratic and uneven inflation rates. Hyperinflation refers to unusually or extremely high rates of inflation.

What Creates Inflation?

It might not make you rest any easier to hear that economists aren’t quite sure what causes inflation. There are a number of different theories on the matter. Some of these include:

  • Cost-push inflation is a type of inflation resulting from significantly increased costs or diminished supply in a single sector of the economy. Inflation resulting from the energy crisis of the 1970s is one historical instance of cost-push inflation.
  • Bad monetary policy is one controllable example of where inflation comes from. If a central bank makes too much money available, the money loses its value and inflation results. Zimbabwe is an example of a place where bad monetary policy has led not just to inflation, but hyperinflation.
  • Demand-pull inflation occurs when prices increase because supply cannot meet demand. Demand-pull inflation happens often in limited sectors of the economy, such as the increased cost of a hot new gift for Christmas.

Effects of Inflation

Inflation can be either negative or positive -- and often times both for the same business. Negative effects of inflation include:

  • Increased costs: As the money is worth less, so do costs increase for businesses. Not only do businesses have pay more for raw materials, they also have to do things like print out new menus and make more trips to the bank for money. These are known as menu costs and shoe leather costs, respectively. Businesses generally also have increased labor costs during inflationary periods, as workers need more money to live on.
  • Market bubbles: Less a result of inflation gone out of control, market bubbles happen when inflation is kept artificially low through the policies of a central bank. Low interests rates are traditionally associated with easy credit and an increased money supply. This, in turn, often leads to speculation in the market and bubbles that go along with it.
  • Economic downturn: The cumulative effect of higher prices and bubbles is a downturn in the economy. When the market corrects itself, the bubble bursts and it is often small businesses and workers that are left holding the bag. When high rates of inflation occur, jobs are often the first place where businesses begin cutting back. This leads to a spike in unemployment, which in turn leads to less consumer spending.

However, not all effects of inflation are bad. The upside of inflation -- even hyperinflation -- includes:

  • Decreased labor costs: Even though you might be shelling out more in dollars for your workers, the real cost of labor, adjusted for inflation, can go down.
  • Decreased debt: Once inflation is greater than your interest rates, you are actually seeing your debt wiped out by inflation.
  • Increased lending: During times of moderate inflation, banks have a tendency to start lending. This increases the overall available capital, causing interest rates to go down.

Mitigating the Effects of Inflation

You aren’t powerless against inflation. While it is unlikely that your business has enough economic weight to combat the effects of inflation, you can insulate yourself from the negative effects. Here are some tips:

  • Long-term planning is the best way to protect yourself. When you invest for the long haul you have factored in the toll inflation will take on your investments. Do not invest in bonds or other types of long-term, fixed-rate investments.
  • Barter allows you to trade things that your company has for goods and services offered by other companies. Note that you still must declare barter on your taxes at its market value.
  • Material investments like new equipment are a great thing to buy when an inflationary cycle begins. Inflation will erode the value of your capital. Why not use it on durable goods that you will still be using after the inflationary cycle is over?

Inflation and Your Business

You don’t need to understand how inflation works to protect your investments and your business. You only need to know what to expect and what you can do about it. The savvy investor can turn a time of hyperinflation into a boom time by making the right moves at the right time.