The Macroeconomics series (III): Inflation can be a friendly monster

In our last article, we talked about inflation, economic growth and how output changes over time. We finished the article by saying that “inflation is not a bad thing in itself”; it is now time to explain why inflation can be good for the economy. This won’t take long, so let’s get started!

Inflation can be defined as a sustained rise in the price level. That means prices will increase over time, making goods and services more expensive, at least in terms of money (we’ll have to spend more $$ / €€ / etc. to buy the same amount of goods and services). But does it really work like that? Why would anyone save money if prices are sure to increase next year?

In a way, inflation does encourage spending rather than saving. Because most goods don’t see a lot of change over time, the increase in the prices of said goods is not always justified. Why would I pay €500,000 for an apartment next year when I can get that same apartment for €450,000 now? A bit of inflation can help people spend money now, helping economic growth. In fact, it makes it easier on those people who choose to spend money, since they can repay their loans using less valuable money (because the price level keeps rising, money becomes less and less valuable). Governments love to borrow money and spend it right now; inflation is really good for them since it helps them handle massive amounts of debt with relative ease.

Actual footage of the Fed repaying a debt of $19 trillion.

Inflation can also be the result of an actual change in the features of a good or service. The most popular example of “inflation” due to an increase in quality is technology. Computers were very expensive when they first came out, but prices became lower after a few years. However, we are experiencing an upward trend again, part of which is due to new computers being way more powerful than older ones. Can your Commodore 64 run Fortnite? Sometimes, an increase in price means we are getting a better product (I’m looking at you, Apple).

John Maynard Keynes gave another reason why some inflation is positive for the economy. The Paradox of Thrift says that, even though saving money is good at an individual level, if everyone chose to save more money, consumption will decrease, lowering aggregate output, which will in turn decrease saving even more, resulting in an overall negative effect. Japan is a great example of this paradox of thrift: Japanese consumers have suffered the effects of deflation for a long time now, so they are pretty confident that the prices will decrease if they wait long enough. If everyone chooses to save money, consumption will be lower and lower. Expectations will also kick in and make it harder for the economy to get going again.

A worrying trend.

Some inflation is actually good for the economy, as it helps boost consumption and find balance between investors and borrowers. Central banks care a lot about inflation, making it their goal to reach a 2% annual inflation rate, because they think it’s the best way to keep businesses going without all the downsides of high inflation (uncertainty, income distribution, etc.). Both high inflation and deflation lead to the same problems, so they think finding a “sweet spot” can help the economy by keeping the price level relatively stable in the short run while also accounting for increases in productivity and quality of goods and services.

In short, a bit of inflation is good for everyone, because it encourages spending (but not too much) and enables investors to lend money and get a fair interest rate in exchange. Expectations of low (but positive) inflation are also good for economic agents, since it becomes easier to make decisions and take risks. I know we all love cheap stuff, but deflation is just as dangerous as high inflation!

 

Read more on inflation and Central Banks:

  • Investopedia: When is inflation good for the economy?
  • JAHAN, S. (2017): “Inflation Targeting: Holding the Line”. International Monetary Fund. Link
  • MANKIW, G. and REIS, R. (2002): What measure of inflation should a central bank target? ECB Working Paper Series, no. 170. Link
  • BLANCHARD, O. et al. (2017): Macroeconomics: a European Perspective. Pearson.

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