Not many people think of it that way, but, inflation is a form of tax also. Inflation reduces the value of your money as it increases the price of goods and services – as a result you can buy less with the same amount of money.
For example, if you earn $100 and pay $5 dollar in taxes, then your real purchasing power is just $95 and not $100.
Similarly if there is an inflation of 5% per year, then you will need $105 to buy stuff worth $100 in an year’s time.
So, inflation works like income tax. The only difference is that every one has to pay it, unlike income taxes.
Debt gets Cheaper
Right now the United States is stimulating the economy by pumping in dollars in the form of bailouts and stimulus packages.
It is mainly doing so by selling T-Bills and other debt instruments and creating debt. It is also doing that by other means, but let’s just stick to the government debt for a while.
Inflation helps you repay lesser than what you actually borrowed.
Assume that there is an annual inflation of 100% in the economy. So that means that 100 dollars today are worth 200 dollars next year.
In this economy if you take a loan of $100 with an interest rate of 5%, you will have to repay $105 dollars after an year. But with an inflation rate of 100%, you have really saved yourself $95!.
This is because the goods and services you can buy today for $105 are much more than what will be able to buy, one year down the line. Since a dollar today – is worth two in an year.
Most people do not think of inflation as a tax mechanism and as a way to reduce the real debt – this angle is completely missed while thinking about stimulus packages and such. More importantly, this angle is sometimes missed, when you are taking a loan or investing money in any other means.