Typically inflation and higher prices are considered bad, but occasionally they may be good for the economy…
Inflation is one of the oldest concepts in economic theory, but experts still struggle to decipher its actual role in the market. It is often seen as a financial plague, which can ruin entire nations if it gets out of control.
Price inflation means that prices have increased in the economy, usually due to monetary inflation, i.e., an increase in the money supply.
Some of the most inglorious examples of hyperinflation are Germany in 1923, Greece in 1944, Hungary in 1946, Zimbabwe in 2008, and surprisingly the U.S. Confederacy during the Civil War. But proponents of inflation say it is not always a bad thing. Some economists consider inflation a necessary evil that has its perks and helps governments manage their economy better.
But can inflation be good for the economy? Occasionally, it can. We will explain how in this article. But first…
What Is Inflation?
Price Inflation is defined as “a sustained increase in the general level of prices for goods and services in an economy over a period of time.” It is measured by calculating the percentage change in the price level of a basket of goods and services purchased by consumers. Typically the percent change is measured over a year. But occasionally, it is calculated over a single month.
Several factors can cause inflation, but it’s typically due to too much money chasing too few goods. Of course, this equation has two sides: too much money or too few goods. Too much money can be the result of excess government printing. When the government prints too much money, it causes the purchasing power of each dollar to decrease. Decreased purchasing power means people have to spend more dollars to buy the same goods or services. As prices rise, it becomes harder for people to afford necessities.
When the quantity of money outstrips the available goods and services, prices will increase as businesses are able to sell items at ever-higher prices. Other factors contributing to inflation include increases in taxes, trade restrictions, or increased energy costs.
A cause for the other side of the equation could be reduced supply without a corresponding reduction in demand. So consumers bid up the price of scarce goods. This type of inflation is typically transitory and is resolved once supply catches up to demand. Supply reduction can result from various causes, including bad weather, which can reduce crop yields or shut down oil refineries. Monopolies like DeBeers Diamond Consortium and OPEC purposely reduce supply to keep prices higher than they would be with free competition.
When inflation gets too high, it can cause problems for an economy, such as higher interest rates, more difficulty borrowing money, and decreased economic growth.
The opposite of inflation is deflation. Deflation happens when consumer and asset prices decrease over time, and purchasing power increases. Competition, increased productivity, and economies of scale can result in declining prices. A good example is what has happened in the computer industry. Computers have gotten increasingly powerful over the last 50 years while simultaneously getting cheaper.
Another cause of deflation is a bursting bubble that destroys capital, such as a stock market or a housing crash. After a crash, people reduce their spending because they feel “poorer”, so producers cut back on production and lay-off employees, resulting in fewer buyers, and the cycle continues.
Arguments for Why Inflation Good for the Economy
Consumers generally consider inflation a bad thing for the economy, but Keynesian economists disagree. They say:
1. Moderate Inflation Encourages Economic Growth
When there is inflation, salaries tend to increase over time. Thus people can buy more goods and services, customer demand increases, and manufacturers sell more goods.
The process impacts the entire system, encouraging growth and promoting employment. Inflation goes a full circle to breathe new life into the whole ecosystem. The downside of this increased demand is that as prices catch up to increased salaries, and then people realize that they don’t really have more purchasing power, just more dollars, so they purchased more than they would have had they known the true cost of things.
2. Inflation Protects the Economy Against Deflation
When prices started to drop in 2008, economists became concerned about deflation. Consumer fear drastically reduced discretionary consumption, and unemployment rose. Rapid deflation due to a collapsing stock market differs from a gradual deflation due to increased productivity and economies of scale. So in an effort to reinflate the stock market and curb fear, the FED embarked on a massive money creation scheme called quantitative easing.
Typically consumers prefer gradually falling prices, but debtors don’t, because it means paying back debts with more valuable dollars. The biggest debtor is the U.S. government, so when faced with a collapsing economy and the prospect of more expensive debt servicing, the FED turned to drastic measures to reinflate the burst bubble.
3. Inflation is Good for Investment
During times of inflation, “excess” money flows into the stock market inflating stock prices. (This is the one type of inflation people like). As prices increase, more people buy stocks, and the market enters a “bull” phase. Conversely, when stocks deflate rapidly traders and investors sell, making the fall even worse.
4. Inflation Encourages Spending
When consumer prices start going up, people tend to spend their money quicker to try to “get ahead of the curve” i.e. to buy before prices rise more. Resulting in people holding onto their money for a shorter time, thus increasing the velocity of money (VOM). A faster VOM makes inflation worse since people spend less time comparison shopping. During the hyperinflation of Weimar Germany, people would get paid daily and rush to spend their money before prices rose later that day.
5. Adjustments in the Labor Market
Nominal salaries aren’t prone to decline. In economic downturns, this wage inflexibility forces employers to lay off workers since they can’t lower their wages, which leads to high unemployment in the job market. Moderate inflation allows real wages to fall even if nominal wages stay the same, which means that labor markets can equilibrate faster.
Disadvantages of Inflation
Needless to say, inflation can have serious negative consequences. We won’t delve deeper into it here, but let’s breeze through the most important drawbacks:
- Inflation leads to economic uncertainty and overall confusion
- It often deteriorates a country’s export, reducing it to the bare minimum
- Inflation undermines the value of personal savings
- The costs of handling inflation are way too high
- When it goes wild, hyperinflation can destroy a national economy
- Inflation interferes with the real value of corporate and government bonds
The list goes on, but these are by far the most negative aspects of inflation.
The Bottom Line
Inflation is a strange phenomenon. It is both well-researched and fairly inexplicable, which is what makes it so interesting for centuries. Most people give it negative connotations, but we analyzed the good aspects of inflation and its positive impacts on the economy.
Have you ever thought about inflation this way? Let us know your opinion about inflation in the comments section!
About the Author:
Justin Osborne is a writer at bestessays.com, he loves to share his thoughts and opinions about education, writing and blogging with other people on different blogs and forums. Currently, he is working as a content marketer at essay writing service.
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