Today's guest post is from OneMint. OneMint is a website dedicated to providing information on personal finance.
In his speech on - Deflation - in 2002, Ben Bernanke made the reference to Milton Friedman's - "helicopter drop" of money to fight deflation. Bernanke and most other central bankers around the world would rather drop money from a helicopter (figuratively), than face the negative effects of deflation..
At the other end of the extreme is - hyperinflation. After World War- 1 - hyperinflation gripped Germany so badly, that some people used banknotes as wallpaper!
Clearly, deflation and hyperinflation are two extremes that have to be avoided at all costs.
What lies between the extremes?
Between the extremes of deflation and hyperinflation there lies - Zero, moderate and high Inflation.
Of this - a high inflation rate is not desirable, as it reduces the real purchasing power of the general public.
It is often seen that the poorest segment of the society stands to lose a lot because of a high rate of inflation. Suddenly, basic necessities become out of reach, and their condition becomes miserable.
A zero level of inflation is more of a theoretical condition, and is rarely seen in the real economy anywhere around the globe. A few journals I read, use - Price Stability and Zero Level of Inflation interchangeably - but they are two different things.
Price Stability is a term used to describe an inflation rate - that is low enough, so that it doesn't affect any business and investment decision. So rather than a zero percent inflation rate - it is more like a very low inflation rate.
Why is a Moderate Level of Inflation Desirable
The real debate is really between - Price Stability and Moderate Inflation.
I believe that a moderate level of inflation is better than a policy that aims at price stability because of the way - wages and salaries are paid, and their impact on the economy.
If a business is not doing well, and it wants to cut costs - one of the prime means that it has at its disposal is - wage cuts.
If a business cuts wages or salaries - that creates a sense of fear among its employees and induces them to spend less.
If each employee spends less - the impact will be a slowdown in the economic activity in the country, and a ripple effect will be seen among other businesses. Since we are in a recession - this point is very easy to understand today.
On the other hand, in the case of moderate inflation - the business doesn't really need to cut salaries to cut costs. If the inflation rate is 4% and the business gives its employees a 2% hike - in real terms - the business still saves 2%.
If there is low inflation in the economy, then
a business can't do this and the consequences are accentuated because of the ripple effect.
The second reason I prefer moderate inflation to low inflation is that a moderate level of inflation helps protect against deflation much better.
The US was running a low inflation in the Greenspan era, and that has compounded (or even created?) the housing bust that we face today. Now, with the economy in a free fall - dire steps such as quantitative easing are being talked about, and there is also a lot of talk about an imminent dollar collapse - as a result of steps like quantitative easing.
The third reason is that I believe that like low inflation - a moderate inflation environment doesn't impact the investment decisions that a business takes. Quite frankly, if an investment is worthwhile at 2% inflation , but not at 5% inflation - you need to get out of that investment altogether.
I think moderate inflation brings to the table the benefit of a low inflation rate, and in addition protects us from economic shocks that can push us in a deflationary environment.
When the focus of the world is away from Deflation - it is going to turn to moderate versus low or zero inflation. I don't think the debate is going to settle any time soon, but I personally think that moderate inflation will help us more than low inflation in the long run.
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