Benefits of Inflation

Readers Question: is the presence of inflation essential to the economy, is there any good that inflation will do to the economy as a whole?

The government have a target for inflation of 2%. In other words they would rather have inflation of 2% rather than 0%.

  • Inflation of 2% seems to be consistent with sustainable economic growth. If inflation fell to 0%, there is a fear of deflationary pressures which could cause a sharp fall in consumer spending.
  • It is also felt that with a low rate of inflation like 2%, it is easier for relative prices to adjust.
  • Also, a moderate inflation rate of 2%, helps nominal wages adjust. For example, with inflation of 2%, you can cut someone’s real wage by 2%, by keeping nominal wages the same. However, if inflation was 0%, you would have to cut wages by 2% to get the same real wage cut. However, an actual nominal wage cut is psychologically much more damaging than keeping wages the same.
  • Inflation of 2%, also helps with a steady erosion in the value of debt.
  • Another issues is that if inflation is fairly constant at 2%, then inflation meets peoples expectations. The biggest costs of inflation occur when the inflation is unanticipated. E.g. people expect inflation of 2%, but firms then find costs have increased 6 – 7%. – This kind of inflation could discourage investment.

Can there be Benefits of A Higher Inflation Rate?

Suppose inflation was well above the target, e.g. an RPI rate of 5% or 6%, could that have any benefits?

At that rate of inflation (5-6%), you will get more of the costs associated with inflation

decline in international competitiveness

increase in uncertainty and confusion, discouraging long term investment.

Menu costs

Decline in real value of savings.

See: Deflation and Inflation

Costs of inflation

One thought on “Benefits of Inflation

  1. there is no any proof or historical evidence that small stable inflation is still good. It is “generally” believed that it is good but actually neither of properties of inflation is researched well enough.

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