| Inflation is Our Friend |
23 June 2003
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Inflation Targets are Too Low
No one who remembers the bad old days of the 1970s and the ridiculous inflation the world suffered can think kindly of rising prices. However, as Japan can attest, and as Germany may find out, inflation is a necessary evil in modern economies. Indeed, current inflation targets in the developed world and the drive for price stability might just be a cure worse than the disease.
Inflation occurs when the value of money in the future is less than the value of money at present. A vicious cycle develops when people decide that spending money is the only way to protect wealth, that is, by storing it in another medium. When money loses value too quickly compared to goods, demand will rise, and the supply of money being spent increases. That cash loses its value even faster. That is the road to hyperinflation.
Deflation is the opposite. When prices are falling, the money in one's pocket is not just retaining value but growing it. Spending today is more expensive than spending tomorrow. In this case, purchases are deferred, prices are cut to attract what little spending exists, and the future value of money increases, further discouraging spending.
Central banks, by cutting interest rates or increasing them, can help manipulate demand and address issues of price inflation or deflation. As long as they can raise or lower rates, the economy can be healed. Yet, there is a bottom at 0%. Further cuts can't really happen, and the economy can only be cured by purchases of bonds for cash or otherwise flooding the market with paper currency, which undermines faith in the unit.
And so, one suggests that 3-6% inflation is desirable, not 0-2%. This gives the central bank room to influence the market, and it gives banks some margin on their loan portfolios (an extra half percent on a loan at 12% means little to the borrower, but on 2% it kills the deal). Above all, it gives consumers incentive to keep money circulating through the economy. Is this hard on those who live on fixed-incomes? Yes, but there are ways to assist them. The alternative is an economy like Japan's.