Can a Little Inflation Be Good?
Let me jump to the end and say right at the start that I don't think so. However, there's a serious argument being made right now among economists and economic policy makers that higher inflation would be good. There's enough of them in the pro-inflation camp that it's worth taking a look at what they're saying.
The Economist has a good article summarizing the current economic thinking that very low inflation can lead to trouble.
The basic case of the pro-inflation camp is that certain kinds of economic adjustments are very hard to make under a condition of stable prices. The classic example is wages, which are (in the term economists use) "sticky on the downside." That is to say that workers will resist wage cuts very strongly — strongly enough that employers find it easier to cut jobs than to cut wages.
When an economic downturn hits during a period of very low inflation, it's hard to adjust. Output goes down, jobs are lost, businesses go bust, asset prices fall, etc. (In other words, exactly what we're seeing right now.)
When there's a little inflation, it's possible to make much the same adjustments with less loss in output. Instead of trying to cut wages, employers can achieve the same result simply by giving raises lower than inflation. That means that fewer jobs are lost, fewer businesses go broke, asset prices don't have to fall as far, and so on. Economists like to speak of a little inflation as a "lubricant" in the adjustment process.
In addition to making the adjustment smoother (all wages and prices go up, but some go up slower than inflation, which amounts to a cut), a little inflation can stimulate the economy, by prompting people to buy now before prices go up (i.e. before the value of their money falls even further).
I've talked before about the downsides of inflation. When prices are stable over the long term, people can focus more of their attention on productive activities and less on keeping track of price changes.
Worse, though, I think higher inflation rates are inherently unstable. An inflation rate under 2% is low enough that inflation can just about be ignored, and a consensus can develop that it's okay. A higher inflation rate, though, becomes noticeable — and there will be pressure to change the inflation rate. Whether the pressure to raise the inflation rate will win over the pressure to lower the inflation rate can't be known, so everyone has to keep their plans flexible so that they can adjust to either possibility. That makes it much tougher to make long term plans — and that, I think, costs our economy quite a bit.
Maybe my thinking is overly influenced by my own experience — I was setting up my first household in 1980-1981, right at the peak of the 1970s inflation. But I don't think inflation is ever a better answer than stable prices.
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