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Why is Moderate Inflation Desirable?

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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.

If you liked this article and wish to read more about the economy, stocks, investing, credit cards or other topics on personal finance please visit us at OneMint and subscribe to his RSS feed.

Last updated on January 27, 2009.

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10 Responses to “Why is Moderate Inflation Desirable?”

  1. Trevor - 14 Year Old Blogger says:

    Good Article.

    This is something to think about.

  2. Ancella says:

    This article is good “food for thought”….

    Another example of hyperinflation is that of the Zimbabwaen Dollar. The official inflation rate has shot thru the roof @ 66212.3% with an exchange value of some 7.1million Z$ to 1USD. Businesses in Zimbabwe have now resorted to accepting only “foreign” currency for trading, etc.

  3. Manshu says:

    Thanks for the kind words – Trevor and Ancella. And a big thanks to Lazy Man for letting OneMint appear on his great website!

  4. kosmo says:

    I’ve seen news stories listing Zimbabwe’s inflation at above 200 million percent. In other words, $2 million of purchasing power on Jan 1, and $2 of purchasing power on Dec 31.

    It would make no sense for shopkeepers to accept ZIM $. It would be impossible to set prices.

  5. Brad says:

    How about no inflation? Realize that inflation causes you to lose money as you are taxed on things that “gain” on paper, yet didn’t really increase in value. Just because the pay cut is not obvious doesn’t mean it isn’t there. The employee is still 2% behind where they were, in your example.

    Brad

  6. Michael says:

    It doesn’t matter how you try and sell it, inflation is a terrible thing. We are being lied to about the level of inflation that we are facing. In the 70s the CPI was calculated using a fixed group of products. Now there are many products that can be tested and the products chosen from year to year can change. Check out the website shadowstats.com for an alternate look at inflation numbers.

    Remember, the only reason it looked like we had a huge stock rally from 03-07 was because we were looking at the numbers in dollars. Priced in gold the dow has gone down every year since 2003. You may claim that gold is just in a big bull market, but gold doesn’t really move in value, only the currencies that it is priced in move. In the 1920s you could buy a decent suit for one ounce of gold, the same is true today.

    In the 70s when inflation was moderate to high the dow went down to one ounce of gold in price. We are going down that path once again by following the advice of Keynesians like OneMint. Can you imagine the dow and gold meeting at 4000?

    You can’t inflate your way out of problems. All you can do is put off the pain until a later date.

  7. Inflation is better than deflation for a healthy economy. Suppose a country has is in deflation. That means prices drop with time. Therefore, there is an incentive for people to wait before they buy because the longer they wait, the less their desired items price will be. Thus people hold on to their money instead of spending it, making the economy slow down.

    Thanks,
    http://www.richerandslimmer.com

  8. Manshu says:

    @Michael: Thanks for bringing up the opposing point of view. People who are interested in exploring Michael’s point further should especially look at what Mitlon Friedman has to say. He is another great economist who reinterpreted the Keynesian way, so reading his works will be great.
    Do a search for Peter Schiff on YouTube and you will get a lot more info on how assets have moved with respect to Gold prices, and that will also help explore this point further. His views on inflation are also similar to Michael’s so that will be good too.

    It is always good to be aware of both sides of an argument.

    @Richer and Slimmer: I agree with you that Inflation is better than Deflation. I guess I will continue to hold that view unless the world sees an Inflationary Great Depression.

    @Kosmo: Zimbabwe has just issued a 100 billion dollar note and you too can get it on eBay :)

  9. Michael says:

    A healthy economy doesn’t do what our economy is doing right now. In a healthy economy, people and companies produce and save money in order to invest in their future. The biggest trends in our country are borrowing and spending. Over 70% of our GDP is consumption. This is not healthy nor is it sustainable over time. We need this recession/depression in order to correct this. That is what a recession is. When the economy becomes out of balance due to a huge bubble or boom, a recession is the cure to the problem. Most people think that a recession is the problem when it is really the solution to an economy that has become unbalanced. Our government is trying to avoid this recession by inflating their way out of it and create demand that isn’t there.

    John Maynard Keynes and his theories are far more destructive to our country than any terrorist. My grandparents raised 6 children in a middle class town on one professional income. It took two professional incomes to raise my brother and I in a similar town. That is the result of inflation. Our average standard of living will continue to go down as long as inflation is a standard part of government monetary policy.

  10. Bobby A says:

    Deflation if harmful to the economy is NOT a defacto reason to consider any amount of inflation good for the economy. If you disagree, offer proof not just opinions.

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