Low Inflation

Nearly all economists advise keeping inflation low. Low inflation contributes towards economic stability – which encourages saving, investment, economic growth, and helps maintain international competitiveness.

Governments usually target an inflation rate of around 2%. This moderate but low rate of inflation is considered the best compromise between avoiding the costs of inflation but also avoiding the costs of deflation (when prices fall)

Benefits of low inflation

benefits-low-inflation

There are many benefits of low inflation.

Firstly, if inflation is low and stable, firms will be more confident and optimistic to invest, this will lead to an increase in productive capacity and enable higher rates of economic growth in the future.

If inflation is allowed to increase because Monetary policy is too lax, there could be an economic boom, but if this economic growth is above the long run trend rate of growth it is likely to be unsustainable, and the boom will be followed by a bust (recession)

This occurred in the UK in 1991 after the Lawson boom of the late 1980s. Therefore maintaining low inflation will help avoid cyclical fluctuations in the economy which can cause negative growth and unemployment.

If inflation in the UK is higher than elsewhere – UK goods will become uncompetitive causing a fall in exports and possibly a deterioration in the current account of the balance of payments. Low inflation and low costs of production enable a country to remain competitive – boosting exports and competitiveness in the long-term.

High inflation has other costs such as menu costs; this is the cost of changing price lists. If inflation is low, we can minimise costs of changing prices lists and shopping around for lowest prices.

How to achieve low inflation

  1. Monetary policy. If inflation is rising above target, the Central Bank can raise interest rates. Higher interest rates raise the cost of borrowing, reduce lending and consumer spending. This moderates economic growth and reduces inflationary pressure.
  2. Control money supply. Monetarists place emphasis on controlling the money supply as they see a direct link between the growth of money supply and inflation. See: why money supply growth causes inflation.
  3. Fiscal policy. If inflation is high, the government can moderate inflationary pressures through tight fiscal policy (e.g. higher income tax will reduce consumer spending). Fiscal policy is rarely used to reduce inflation.
  4. Supply-side policies/productivity growth. In long-term, some inflationary pressures can be reduced by supply-side policies. For example, in the 1970s powerful trade unions were blamed for being able to increase wages – leading to wage pull inflation. With weaker unions, wage growth has been lower and inflation weaker.
  5. Low commodity prices. Some inflationary pressures are beyond the scope of Central Bank/government. Rising oil prices almost inevitably causes cost-push inflation, and this is difficult to solve.

Problems of achieving low inflation

fall-ad-full-capacity

If a Central Bank increases interest rates to reduce inflation, it will cause a fall in aggregate demand, lower economic growth and could result in recession and higher unemployment.

unemployment-inflation-trade-off-78-11Fall in US inflation 1980 to 1983 – caused a rise in US unemployment.

For example, in the early 1980s, the Conservative government raised interest rates and pursued tight fiscal policy. This reduced inflation, but also caused the deep recession of 1981 and unemployment of 3 million.

However, monetarists believe that inflation can be reduced without conflicting with other macroeconomic objectives. This is because they believe that the Long Run Aggregate Supply is inelastic; therefore any fall in AD will only cause a temporary fall in Real GDP, but after a short period the economy will return to the full employment level of National Output.

See: Is there a trade-off between inflation and unemployment?

Can inflation be too low?

global-inflation-world-bank

Global inflation rates have been low since the financial crisis of 2008, but some economists argue this has led to the sluggish rates of economic growth in the Eurozone and elsewhere.

The experience of Japan in the 1990s shows that very low rates of inflation can cause many serious economic problems. Inflation has been very low in the 1990s and 2000s, but Japan has suffered from growth well below its long-term average and has seen unemployment rise. Rising unemployment has many serious costs such as increased inequality, higher govt borrowing and a rise in social problems. In this case, economic growth is arguably a more important objective even if it conflicts with higher inflation.

Economists have been concerned about very low inflation rates in the Eurozone 2010-17. Countries such as Greece and Spain have seen deflation, but unemployment rates of over 25%.

Conclusion

Usually, low inflation has many benefits which help improve the economic performance of the economy such as increased investment.

However in some circumstances keeping inflation low may be unsuitable for the economy. If there was a supply-side shock to the economy keeping to the inflation target may cause increased unemployment and lower growth which is very undesirable. Therefore the govt should perhaps aim for low inflation but have a degree of flexibility if this appears unsuitable to the current economic climate.

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Published September 28, 2017 | Tejvan Pettinger
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