Inflation tax is the financial loss of value incurred by a holder of cash. For example, if you hold a $1000 bill for one year, then it will purchase on what $980 would have bought a year ago. Inasmuch as excess bank reserves attract nominal interest, the value is still lost (Mankiv, 2012).
Inflation Tax and Creation of Inflation by Central Bank
Inflation tax is a financial loss of value. A portion of one’s loss goes to finance printing of the note and catching the counterfeits, among other reasons. The rest is taken as tax, but not the actual tax because it is not a fee that the government charges (Mankiv, 2012). It is considered tax because the government does profit if it is a net-debtor because it results in the shrinking of government's debt over time. This is contrary to the theoretical assumption in which the inflation rate is factored into the interest accrued on government’s debt. This is one of the reasons why the central bank permits the occurrence of inflation; which gradually diminishes government’s debt hence facilitating avoidance of debt crisis.
How Inflation Affects Savings and Investments
Inflation erodes purchasing power of money hence devaluing savings. Additionally, inflation is accompanied by low-interest rates making it harder to get returns that are commensurate with the escalating costs of living. Rising inflation drives the prices of bonds thus becoming less lucrative because the interest rates are likely not rise at the same rate as cost of living (Mankiv, 2012).
Inflation and Relative Prices
The price of an item in terms of another is called relative price. Simply put, relative price is the ratio of two prices. Inflation is caused by a higher rise in money supply than the underlying economic growth, thus varying the unit of measure. Inflation weakens the value of an individual unit of currency through an influx of in circulation. For instance, if there are only twenty dollars in the world, and you have two, then your dollars are very valuable. However, if there twenty trillion dollars and you have two of them, your dollar value is virtually worthless. As inflation rise, one's savings and investments are devalued.
Reference
Mankiv, G. (2012). Macroeconomics. Basingstoke: Worth Publishers.
