Is inflation a good or bad thing? Why do governments want some inflation?
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.
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
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.
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.
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.
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 (2010) 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 3.5%, after taxes that's 2.625%, but less than 0% after (long term) 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.
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.
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.
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.
Inflation is a bad thing. It makes it much more difficult for people to compare prices and prosperity over a long period of time. This causes people to ignore the wisdom of their elders (who remember prices from a long time ago).
Back in my day, you could get a burger and fries for 15 cents -- a dime for the burger, and a nickel for the fries.
But the minimum wage was only a quarter an hour! That doesn't help me decide if things have gotten better or worse.
How long is "a long period of time"? That depends on the inflation rate.
At 1 percent per year, 50 or 100 years is "a long time".
At 10 percent per year, 5 or 10 years.
At 100 percent per year, a few months.
Because of the Spanish conquests of gold and silver mines in Mexico and Peru, prices in the sixteenth century rose by a factor of 5.5 during the century. This inflation was recognized as causing lots of social and governmental problems. Note that this means an average inflation rate of 2 percent per year for a century is known to be a very bad thing.
There are several reasons that most governments want some inflation:
- The "Phillips curve" economic theory suggested that increasing the inflation rate would reduce the unemployment rate. This might not work in the long-term, but in European countries, the next election is never very far off.
- A government that wants to spend money on expensive projects or ideas wants people to "ignore the wisdom of their elders" about how expensive the projects are.
- Most governments owe lots of money in their own currencies. Inflation lets them pay their debts with devalued currency. In other words, it is a gradual way to default on debt, usually without provoking a political crisis.
- Many countries have lots of voters who owe more money on home mortgages than they have saved in deposit accounts. Inflation lets these voters pay their debts with devalued currency.
- Inflation tends to reduce the value of a country's currency, which often helps tourist-oriented businesses, export-oriented businesses, and businesses that compete against imports. It also helps the workers at these businesses.
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.