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Is inflation a good or bad thing? Why do governments want some inflation?

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10 Answers 10

Sensitive topic ;)

Inflation is a consequence of the mismatch between supply and demand. In an ideal world the amount of goods available would exactly match the demand for those goods.

We don't live in an ideal world.

  • Too much supply: if there are too many of a good chasing too few customers then the result is a reduction in prices to find the ideal point at which consumers will spend (year-end sales, for instance). That may be below cost and then businesses fail.
  • Too much demand: if there are too many consumers chasing too few products then the result is an increase as those who are prepared to spend more do so.

One example of oversupply is dollar stores where you can buy remainders from companies that misjudged demand. Most recently we've seen wheat prices rise as fires outside Moscow damaged the harvest and the Russian government banned exports.

And that introduces the danger of inflation.

Inflation is a signal, like the pain you feel after an injury. If you simply took a painkiller you may completely ignore a broken leg until gangrene took your life.

Governments sometimes "ban" inflation by fixing prices. Both the Zimbabwean and Venezuelan governments have tried this recently. The consequence of that is goods become unavailable as producers refuse to create supply for less than the cost of production.

As CrimonsX pointed out, governments do desperately want to avoid deflation as much as they want to avoid hyperinflation.

There is a "correct" level and that has resulted in the monetary policy called "Inflation targetting" where central banks attempt to manage inflation into a target range (usually around 2% to 6%).

The reason is simply that limited inflation drives investment and consumption. With a guaranteed return on investment people with cash will lend it to people with ideas. Consumers will buy goods today if they fear that the price will rise tomorrow.

If prices fall (as they have done during the two decades of deflation in Japan) then the result is lower levels of investment and employment as companies cut production capacity. If prices rise to quickly (as in Zimbabwe and Venezuela) then people cannot save enough or earn enough and so their wealth is drained away.

Add to this the continual process of innovation and you see how difficult it is to manage inflation at all. Innovation can result in increased efficiency which can reduce prices. It can also result in a new product which is sufficiently unique to allow predatory pricing (the Apple iPhone, new types of medicines, and so on).

The best mechanism we have for figuring out where money should be invested and who is the best recipient of any good is the price mechanism. Inflation is the signal that investors need to learn how best to manage their efforts.

We hide from it at our peril.

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A very nice write-up. –  George Marian Aug 28 '10 at 16:16
    
+1 Nice explanation! –  d-_-b Sep 8 '10 at 14:37
    
+1 , this helps me to understand the point in which this video mentioned, "central bank set up inflation rate targeted of 2 to 3% per year". investopedia.com/video/play/what-is-inflation#axzz1zpjaMcCW –  kitokid Jul 7 '12 at 5:50
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How does inflation drive both investment and consumption? If I have some money in my bank, and I'm trying to decide what to do with it, I can either spend it (consumption) or save it (invest it). It doesn't make sense to me that inflation would tell me to do both. –  Cory Klein Jul 16 '12 at 18:29
    
A quibble w/your characterization of predatory pricing. Selling innovative products at a premium is not predatory. Selling basic foodstuffs to starving people after a natural disaster at ten times the normal price may be so, though even reasonable people can argue the free market vs social justice pros and cons of this. In any case, it has little to do with why we have inflation, and whether that's a useful thing or not. It just seems like editorializing, IMHO. –  Rick Goldstein Mar 28 '13 at 21:21

Basically, in any financial system that features fractional reserve banking, the monetary supply expands during times of prosperity. Stable, low inflation of 2-4% keeps capital available while keeping the value of money stable. It also discourages hoarding of wealth.

Banks aren't vaults. They take deposits and make an explicit promise to repay the depositor on demand. Since most depositors don't need to withdraw money regularly, the lend out the money you deposited and maintain a reserve sufficient to meet daily cash needs.

When times are good, banks lend to people and businesses who need capital, who in turn do things that add value to the overall economy. When times are bad, people and businesses either cannot get capital or pay more for it, which reduces the number of times that money changes hands and has a negative impact on the wider economy.

People who are trying to sell you commodities or who have a naive view of how the economy actually works decry the current monetary system and throw around scary words like "fiat currency" and "inflation is theft". What these people don't realize is that before the present system, where the value of money is based on promises to repay, the gold and silver backed systems also experienced inflation. With gold/silver based money, inflation was driven by discoveries of gold and silver deposits

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Hey look at that, a sensible comment in the sea of conspiracy theories. –  Jim Aug 29 '10 at 3:50
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You're correct. Large discoveries of gold and silver can inflate prices where gold and silver are used as money. The large discoveries of huge piles of fiat currencies (see FED balance sheet over the past two years), however, dwarf any metal discoveries (money.stackexchange.com/questions/517/how-much-is-inflation/…) –  Muro Sep 29 '10 at 1:00
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@Muro: Sure. That 28% drop in 1879 wasn't the equivalent of an all year sale on everything. It was the tail end of a devastating depression, triggered in the US by the demonetization of silver, which choked off the money supply and wiped out farmers and manufacturers. This led to 30 years of deflation, which inspired folks like William Jennings Bryan and his famous "Cross of Gold" speech. –  duffbeer703 Sep 29 '10 at 2:10

Inflation, like trade deficits or surpluses, have winners and losers in an economy. Clear losers are people who are on a fixed income, as they often have a fixed income and a prices keep on going up, meaning they can afford less. Numerous articles on the internet discuss the inflation of the 1970s, here are Google's results.

I'm not so sure that governments want "some inflation" as much as they desperately want to avoid deflation.

Deflation means that the price for today's product, like a car, will decrease in price tomorrow (or a month from now) which creates a powerful incentive for people to put off a purchase until later, which brings consumer demand down in a country's economy.

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I always put off buy technology for this exact reason. I never buy cutting edge. It's just the nature of the way technology is developed, however, not because of deflation. I get kicks out of a good deal - then I give my money to brewer. ;) –  d-_-b Sep 8 '10 at 14:44

Inflation is what happens, it is not good or bad in and of itself. But consider the following.

In a thriving economy with low unemployment, people are buying, buying, buying. People are not saving for later, they are buying now. Industry is also making purchases. Now. From economics 101: high demand for goods/services leads to relative scarcity leading to higher prices. Inflation tends to be one byproduct of a thriving economy. Governments want the thriving economy that brings inflation with it.

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You and ten of your buddies are dropped on a deserted island. Do all of you immediately start spending? No. You have nothing to spend. You have to produce something before you can spend. Production comes before consumption. Also, where does industry get the money to buy machinery and other capital to increase production? From loans which come from savings. If an economy is to thrive there has to be savings so that the savings can be used to improve productivity. See the following: (money.stackexchange.com/questions/517/how-much-is-inflation/…) –  Muro Aug 26 '10 at 3:07
    
Actually it comes from the earth. We take from the earth. So it's "eco" not to inflate or consume too fast, as that will ultimately put a strain on natural resources. –  d-_-b Sep 8 '10 at 14:45

Although there are some good points made here as to the cause of inflation (mostly related to supply and demand), azcoastal does head in a different direction, one which I myself was going to take. Let me give a different angle, however.

Another cause of inflation is the printing of money by the government (not simply replacing old money with new, but adding to the total money in circulation).

If the government doubles the amount of currency in circulation (for the sake of argument and easy math), the value of all money decreases by a factor of 2. That's inflation, and the way G. Edward Griffin in The Creature From Jekyll Island puts it, it's really tantamount to a hidden tax. In a nutshell, the federal government wants to buy some cool stuff like new tanks or planes, or they want to give a bunch of food stamps to poor people, or they want to fly their private jets around, but they don't have enough money from taxes. So, they print money and spend it and buy their stuff. Because they've just increased the money in circulation, however, money loses its value. For example, your savings has dropped in value by half, despite the fact that the same number of dollars is in your savings account.

This is just a way the government can tax you without taxing you. They buy stuff and you now have less money (i.e., your retirement is worth less) and you don't even know you just got taxed. Makes me sick that we let our "leaders" get away with this.

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The classic definition of inflation is "too much money chasing too few goods." Within a tight range, say 1-3%, inflation is somewhat benign. There's a nice inflation widget at The Inflation Calculator which helps me see that an item costing $1000 in 1975 would now be about $4000, and $1000 from 1984 till now, just over $2000. I chose those two years to make a point. First, I am 48, I graduated college in 1984, so in my working life I've seen the value of the dollar drop by half. On the other hand it only took 9 years from 75-84 to see a similar amount of inflation occur.

I'd suggest that the 26 year period is far more acceptable than the 9. Savers should be aware of their real return vs what was a result of inflation. I'm not incensed either way but logically have to acknowledge the invisible tax of inflation. I get a (say) 6% return, pay 2% in tax, but I'm not ahead by 4%, 3% may be lost to inflation. On the flip side, my mortgage is 5%, after taxes that's 3.6%, but only .6% after inflation. So as a debtor, I am benefiting by the effect of inflation on what I owe.

Interesting also to hear about deflation as we've grown used to it in the case of electronics but little else. Perhaps the iPad won't drop in price, but every year it will gain features and competitors will keep the tablet market moving. Yet people still buy these items.

Right now, there's not enough spending. I'd suggest that, good financial advice aside, people as a whole need to start spending to get the economy moving. The return of some inflation would be a barometer of that spending starting to occur.

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In general the consensus is that a small amount of inflation (usually 1.5-2% per year) is desirable. That is why the Federal Reserve sets its inflation target in that range. The reasons why are quite complex though.

One reason is "wage stickiness" - ie., the observed phenomenon that employers don't like to cut wages. Having a small rate of inflation means that when wages are steady in nominal terms, they are actually falling in real terms. This gives employers more flexibility.

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Inflation is an increase in the money supply. Increases in consumer prices follow from inflation. It's not the same as inflation.

Some inflation is necessary for a growing economy. If your gross national product is only $1,000, then you can get away with having less money than if your gross national product is $1 trillion.

Inflation beyond this, though, is used to allow governments to live beyond their means. If there is more money chasing the same amount of goods, prices will rise. There is truth in what azcoastal says about this kind of inflation. It's theft.

Governments like inflation because it allows them to pay off their debts with cheaper money.

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All debtors like inflation. Historically, folks with lots of illiquid assets like farmers need debt and love cheap money. Folks with lots of variable liabilities like factory owners hate cheap money, because it raises their raw material cost. –  duffbeer703 Nov 4 '10 at 3:02

If there's no inflation (or alternately there's deflation) people would tend to sit on money and wait for the prices to drop. This in pretty bad for pricier stuff like real estate/housing industry where a few percent can make a big difference.

For a growing economy a small inflation is good as people would go out and buy new stuff when they want it knowing they will not get a better deal if they wait a year or so.

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In that case, the demand for memory and hard drive space should be frozen because in the last ten (and more) years we've seen the price drop drastically. Clearly companies should be waiting around knowing that the price will be cheaper in the future. In fact, we see the very opposite. You completely forget the wealth effect: when people begin to feel richer, they'll spend more money. So at some point in a deflationary cycle, people begin to feel very rich and begin spending. See this: globaleconomicanalysis.blogspot.com/2013/12/… –  Question3CPO Feb 11 at 19:12

Inflation is theft! It is caused when banks lend money that someone deposited, but still has claim to - called fractional reserve banking.

On top of that, the Federal Reserve Bank (in the US) or the Central Bank of the currency (i.e. Bank of Japan, European Central Bank, etc.) can increase the monetary base by writing checks out of thin air to purchase debt, such as US Treasury Bonds.

Inflation is not a natural phenomenon, it is completely man-made, and is caused solely by the two methods above.

Inflation causes the business cycle. Lower interest rates caused by inflation cause long-term investment, even while savings is actually low and consumption is high. This causes prices to rise rapidly (the boom), and eventually, when the realization is made that the savings is not there to consume the products of the investment, you get the bust.

I would encourage you to read or listen to The Case Against the Fed by Murray N. Rothbard - Great book, free online or via iTunes.

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would you consider rephrasing your first sentence? I think it's more inflammatory than is likely necessary to convey your point. Note that I'm neither agreeing nor disagreeing, just suggesting that calling anything "theft" that many others might not is probably more contentious than is ideal for a Q&A site. (At a minimum, removing the exclamation point might help.) –  Jaydles Aug 28 '10 at 20:50
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Inflation is a natural phenomenon, unless you're an advocate of a strict barter economy. Economies need a medium of value (ie. money) if you use a commodity like gold, inflation is driven strictly by the supply of gold, which tends to grow over time as it is dug from the ground. Read about the affects of inflation on Imperial Spain if you don't believe me. –  duffbeer703 Aug 29 '10 at 3:49
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Inflation is simply the expansion of the money supply, yes when government run fiate currencies engage in inflationary policies it is on the scale of theft but this doesnt apply to all inflation. Under a gold/silver standard you still will have inflation due to new discoveries fo gold/silver but this pales in comparison to government inflation. –  Shard Feb 25 '11 at 2:42
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Inflation is not natural. Its the product of FIAT currency and the manipulation of the value of the FIAT currency through central banks. –  WeNeedAnswers Jun 7 '12 at 1:54
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The gold standard was not subjective to the amount of gold out there in the world, but the amount that a country actually had stored in its national vaults and what the currency was pegged at. This was to prevent inflation. Inflation during the gold standard only happened when a country left the gold standard and tried to return after printing money that was not attached to gold store. –  WeNeedAnswers Jun 7 '12 at 1:58

protected by Chris W. Rea Mar 28 '13 at 12:34

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