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.
Decline in real value of savings.