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come under pressure as their values plunge. Also financial institutions (banks) see shrinking or even negative returns on their investments (which are mostly in loans such as mortgages) since the interests they collect on their loans can no longer compete with inflation. After all, collecting 7% interest when inflation is at 8% is like losing 1%. Thus they are left with less money to loan on which they would have to charge a higher interest to stay ahead of inflation. This means that the banks would have to pay higher interests to their depositors in order to attract more incoming cash to loan out.

Alarmed by their shrinking savings and lured by higher interest, people would eventually divert more money into savings (or other high interest investments) therefore curbing spending. Companies will suddenly be faced with diminishing demand for their products and services while they might have invested heavily in anticipation of increased demand. As earnings tumble the economy is suddenly faced with the real threat of rapid slowdown leading to a recession.

More On Inflation

Short-term inflation is caused by an imbalance in supply and demand. As demand for products and services increases, supplies become more depleted causing prices to rise. Also, if demand is constant but supplies for one reason or another dwindle, inflation could set in. An example of this is evident during war times. During such times supply channels are choked and resources are diverted to war efforts as a country suffers through the conflict, and the public finds itself in a shortage. The same is true for economies that are heavily dependent on export and import when for some reason (political conflict, government corruption, embargoes, etc.) they are cut off from their global trading partners. …