Inflation gets a bad rap.  Sure, runaway inflation is horrible for any economy; nobody is denying that.  But is inflation always bad for society?  Many, if not most, of economists think not.  In fact, inflation can have some powerfully positive effects on the economy.  Following are some of the most-commonly cited benefits of inflation.

Is Moderate Inflation Good For You?

When inflation hits double digits, everybody panics for good reason.  An unstable pricing platform makes it difficult for businesses and consumers to judge their future purchasing power and discourages productive investment due to increased economic risk and uncertainty.  But with inflation consistently below 4% in practically all of the developed world, are there really significant benefits of forcing it even lower?

For starters, there is little if any empirical evidence that lower inflation serves to increase economic growth once inflation is below a reasonable limit, say 5%.  A plot of inflation rates versus economic growth of all developed economies from 1960 to present does not form any discernable trend.  That is, there doesn’t appear to be a correlation between inflation (once below a reasonable limit) and economic growth (Source: OECD: pdf opens in another window).  But that doesn’t necessarily mean that inflation is good for you but rather, only that moderate inflation isn’t particularly bad.  For some concrete reasons, we have to dig deeper.

Inflation Greases The Gears Of Capitalism

Wages tend to be fairly inelastic.  People are loathe to take a cut in pay for any reason.  Unfortunately, sometimes wages need to be cut in failing industries or regions in order to free up capital for more productive uses elsewhere.  Fortunately, inflation provides a way out of this dilemma.  While workers probably wouldn’t be willing to accept less money in absolute terms, they would be far more accepting of flat wages for a year or two while inflation ranges 3-4%, which is effectively a pay cut in real terms.  These sorts of phantom capital reallocations simply wouldn’t be possible in a world without inflation.  Since this type of inflation allows capital to be allocated more efficiently than it otherwise would be, it will tend to boost economic growth in a situation where it might otherwise be retarded.

Another advantage of moderate inflation is that it leaves room for negative real interest rates to boost economic activity.  If interest rates are 2% at a time when inflation is 4%, borrowers are essentially being paid to borrow money.  Since interest rates can never go below 0% in nominal terms, this sly economic tool would not be possible in a world without inflation.  Of course, many economists doubt the necessity of negative real interest rates but there is no doubt it has been used effectively at times.

Finally, persistent moderate inflation allows firms with marginal pricing power push through price increases under the guise of inflation.  If inflation is non-existent, any attempt to raise prices by firms will certainly be noticed and heavily scrutinized; however, if the public comes to expect that prices will rise over time due to inflation, it will be easier to raise prices.  This is because consumers don’t pay too much attention to the magnitude of moderate price increases:  they just notice they happen.  If a firm raises prices by 4% when inflation is running at 3%, that amounts to a 1% real rise in prices.  Consumers probably won’t question the increase, though, because it’s small and not dramatically higher than the inflation rate.  Since consumers expect inflation, they accept the price increase without question.  This leads to higher profits for firms and eventually higher wages and lower unemployment than what might exist otherwise.

Like what you see here? Subscribe to my feed for more great content every day!

Related Posts

• Do Official Inflation Numbers Match Your Experience?
• Now vs Then: The Current Crisis And The 80’s
• The Odds Of Uncle Sam Defaulting Are On The Rise
• Why Is The Dollar Falling?
• Between A Rock And A Hard Place: The Federal Reserve’s Quandary