Inflation refers to the increasing prices of goods and services. It means the purchasing power of a currency decreases. Inflation affects an economy in several ways. Thus, it impacts every walk of life, including businesses.
Controlled inflation is not always bad for an economy. Businesses flourish when inflation rates are under control. However, negative inflation or hyperinflation can cause severe economic problems.
As inflation impacts an economy and individuals get affected, every business in that economy gets affected. Businesses may face severe consequences from increased costs of production to changing borrowing costs.
Let us discuss some key impacts of inflation on the economy and businesses.
What is Inflation?
Inflation is the decreasing purchasing power of a currency. In other words, it means increased prices of goods or services than in previous days.
There are no set rules on how high an inflation rate can go or remain acceptable. In developed countries like the US, an inflation rate above 4% will be considered high. In developing countries, an inflation rate of close to or above 10% will be considered high.
Inflation can have different impacts on an economy at different levels. For instance, a high inflation rate will have severe consequences on an economy. The central bank would take drastic measures to control the high inflation rate. That, in turn will impact businesses and consumers as well.
Common Causes of Inflation
We should consider the causes of inflation to fully understand its impacts on a business and an economy overall. Several reasons cause inflation rates to rise.
1) Demand-Supply Rule
The excessive demand and lower supply are the most common factor that causes inflation rate to go up. When an economy or a business cannot meet the consumers’ demand, the prices of goods increase. That causes inflation rates to go up.
2) Cost-Push Rule
In a cost-push rule, the cost of production of goods increases. Eventually, the businesses start increasing the prices of goods. That lowers the purchasing power of consumers. In turn, that causes inflation rates to go up.
3) Excessive Money
The excessive money phenomenon relates closely to the demand-supply factor. When there is excessive money in an economy, it empowers consumers. They buy more and supplies go down. Hence, the prices start increasing causing inflation.
4) Built-In Economic Factors
Some economic factors are built-in in every economy that causes inflation rates to increase. The GDP growth rate, the monetary policy of a country, and interest rates are some of the key built-in factors that cause inflation rates to increase.
How Inflation Affects a Business?
Inflation has broader impacts on an economy. It means consumers and businesses get affected directly.
1) Increased Cost of Borrowings
In a low to moderate inflation environment, the interest rates will remain steady. As inflation keeps rising, the central bank will likely increase the interest rates to counter the inflation rate.
Increased interest rates are good for investors. However, it means an increased cost of borrowings for a business. The cost of capital will increase for a business with increased interest rates.
2) Increased Investing Activities for Businesses
Increased interest rates come with a benefit for investors as well. Businesses can also use higher interest rates to their advantage. Many businesses with surplus cash turn to capital investment projects that otherwise would have been put on hold.
Higher interest rates encourage businesses to increase investing activities.
3) Lower Purchasing Power and Lower Sales
High inflation rates decrease the purchasing power of a currency. It means consumers will spend less or will be able to buy less than earlier. In an economic cycle, it means the businesses will see lower sales.
High inflation causes lower business activities. That in turn affects the economy and business sales.
4) Increased Costs of Production
When inflation rates go up, the total cost of doing business increases. In particular, the cost of production increases as raw material prices, transportation costs, and overhead costs increase.
Businesses would increase prices eventually. It would result in lower sales at first until the economy absorbs the inflation impacts.
5) Positive Effects of Inflation on a Business
Rising inflation rates can have negative impacts on a business and the economy overall. However, if inflation rates are kept under control by the central banks, they can bring positive impacts on the economy as well.
Some businesses in specific industries can take advantage of inflation. For example, investment banks and financial services can receive higher profits with increased interest rates. Similarly, some businesses will increase their product prices to adjust to the inflation effects.
6) Increased Consumer Spending
When inflation rates rise too much, central banks increase interest rates. It doesn’t sound good for businesses. However, individuals receive a higher return on investment with increased interest rates.
It means consumers can spend more with increased profits. Eventually, it will increase business sales and push the economy on the right track.
7) Lower Cost of Borrowings
If inflation rates are kept under control, central banks will keep the interest rates lower. It can lead to lower costs of borrowings for businesses. However, businesses must plan well as increasing inflation rates may compel central banks to increase the interest rates later.
8) Increased Business Growth
When consumers anticipate inflation rates to go further up, they tend to spend more. It is a commonly observed phenomenon that consumers tend to buy more to save money with increased prices later. More spending from consumers increases business growth.
9) Protecting your Business from Inflation Effects
Controlling inflation does not come easy for governments and central banks all over the world. Businesses can only take preventive measures to mitigate the risks arising due to high inflation rates.
10) Managing Debt Financing
As interest rates increase in an increasing inflation environment, businesses must plan for managing debts. They can obtain debt financing when inflation rates stay moderate or low. Debt refinancing also remains a good choice for managing higher costs of borrowings.
11) Inventory Management
More businesses are turning towards lean inventory management systems. However, when inflation rates go up, the costs of inventory management rise. Thus, managing inventory efficiently can lower costs.
12) Cost of Production
Rising inflation rates would eventually increase the cost of production for any business. Effective inventory management, price negotiations, and working capital management can help you control the total cost of production.
13) Price Adjustments
It is inevitable to perform product price adjustments when costs of production increase. All businesses tend to pass on the inflation effects to the consumers. However, businesses cannot survive without carefully adjusting the product prices to reflect the inflation effects.
Businesses can also take some other measures to control the impacts of inflation. For instance, better forecasting and budgeting methods can help a business mitigate the inflation impacts. Similarly, businesses with large cash reserves can tolerate inflation better than others with low cash reserves.
Inflation is the measure of increased prices of goods and services. It lowers the purchasing power of a currency. Businesses bear the brunt of high inflation rates. However, controlled inflation can bring several benefits to the economy and businesses. Businesses can also take proactive measures to protect themselves against rising inflation rates.