Have you ever heard the stories of how milk was a nickel back in the day? Or salaries of $10,000 in 1975? We can thank inflation for the higher prices and wages we have today. We’ve experienced tame inflation during the past few decades, averaging about 2%. This is a far cry from the 70’s and 80’s when it crept up to 13.5%. We haven’t really experienced inflation’s drunken uncle, deflation, where prices go down over time. This was last seen during The Great Depression.

The Federal Reserve actually targets for the US economy to have moderate inflation, right now roughly 2%. But why would they want higher prices? I certainly don’t want to pay more for food or my next iPhone! To understand the answer to this question, first you have to understand who wins and loses when there is inflation.

Winners

Equity Owners: inflation can lead to higher input costs, but businesses can negate this by selling at higher prices. Let’s use a restaurant as an example. If a restaurant has to pay more for food and labor, the owner can simply raise menu prices. The owner of the restaurant can keep making money by raising prices, as long as inflation doesn’t hamper demand.

Borrowers (fixed rate): those who borrow money at a fixed interest rates actually benefit from inflation. Let’s use a mortgage as an example. Frank takes out a $80,000 mortgage to buy a $100,000 home at 3% for 30 years. This comes out to roughly $350 per month. Inflation should drive up Frank’s income, yet his $350 mortgage will remain the same. This payment will become a smaller percentage of his pay.

Losers

Lenders (fixed rate): those who lend money to others, at fixed rates, will have their return eaten away by inflation. The bank who lent Frank $80,000 will earn 3% each year. If inflation hits 4% though, they will actually lose 1% after considering the effects of inflation. The interest rate money is lent at should consider future inflation expectations. An unexpected rise in inflation will eat away more of the return. Interest rates and bond values move in opposite directions. A rise in rates will lower the value the bank can sell the mortgage.

Cash Holders: inflation eats away at the value of cash over time. 3% inflation over 20 years cuts purchasing power in half. A pile of cash saved up would only be able to buy half as much stuff.

Consumption Delay: people who delay a purchase will have to pay more for the same thing. The new car, home, and furniture will be more expensive 2 years out.

Borrowers (variable rate): those who borrow money at variable interest rates will probably see their rates rise during inflationary periods. This raises the cost to service the debt, raising the monthly payment. More money will go towards interest, rather than paying back borrowed money.

Inflation can benefit some and set others back. But moderate levels can be a net benefit for the economy as a whole. First, it encourages money to be spent now, rather than waiting until goods are expensive. Second, it encourages money to be borrowed, then spent. Third, it encourages those sitting on cash to invest their money to reduce or beat the impact of inflation. All of these things help the economy as a whole, but only when done in moderation.

Deflation does just the opposite. It encourages delayed spending since goods and services become cheaper. It discourages borrowing and encourages cash hoarding. None of these equate to healthy economic activity.

So, at the end of the day, we’d rather see moderate inflation to grease the wheels of the economic system. If we’re going to error on one side, we’d pick inflation. It’s the better alternative to its drunken uncle.