Inflation

:This page is on the topic of price inflation in economics. For alternative meanings see inflation (disambiguation).

The role of inflation in the economy

One effect of small steady inflation is that it is difficult to renegotiate some prices, and particularly wages and contracts, downwards, so that with generally increasing prices it is easier for relative prices to adjust. Many prices are "sticky downward" and tend to creep upward, so that efforts to attain a zero inflation rate (a constant price level) punish other sectors with falling prices, profits, and employment. Thus, some business executives see mild inflation as "greasing the wheels of commerce". Efforts to attain complete price stability can also lead to deflation (steadily falling prices), which can be very destructive, encouraging bankruptcy and recession (or even depression).

Related Topics:
Sticky - Deflation - Bankruptcy - Recession - Depression

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Many in the financial community regard the "hidden risk" of inflation as an essential incentive to invest, rather than simply save, accumulated wealth. Inflation, from this perspective, is seen as the market expression of what the time value of money is. That is, if a dollar today is worth more to someone than a dollar a year from now, then there should be a discount in the economy as a whole for dollars in the future. From this perspective, inflation represents the uncertainty about the value of future dollars.

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Inflation, however, above relatively low levels is generally considered as having increasingly negative effects on the economy. These negative effects are the result of "discounting" previous economic activity. Since inflation is often the result of government policies to increase the money supply, the government contribution to an inflationary environment is a tax on holding currency. As inflation increases, it increases the tax on holding currency, and therefore encourages spending and borrowing, which increase the velocity of money, and therefore reinforce the inflationary environment, a "vicious circle". To extremes this can become hyperinflation.

Related Topics:
Money supply - Tax - Hyperinflation

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• Increasing uncertainty may discourage investment and saving.
• Redistribution
• It will redistribute income from those on fixed incomes, such as pensioners, and shift it to those who draw a more flexible income, for example from profits and most wages which may keep pace with inflation.
• Similarly it will redistribute wealth from those who lend a fixed amount of money to those who borrow (if the lenders are caught by surprise or cannot adjust to inflation). For example, where the government is a net debtor, as is usually the case, it will reduce this debt redistributing money towards the government. Thus inflation is sometimes viewed as the "inflation tax".
• International trade: If the rate of inflation is higher than that abroad, a fixed exchange rate will be undermined through a weakening balance of trade.
• Shoe leather costs: Because the value of cash is eroded by inflation, people will tend to hold less cash during times of inflation. This imposes real costs, for example in more frequent trips to the bank. (The term is a humorous reference to the cost of replacing shoe leather worn out when walking to the bank.)
• Menu costs: Firms must change their prices more frequently, which imposes costs, for example with restaurants having to reprint menus.
• hyperinflation: if inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply.

In an economy where some sectors are "indexed" to inflation, while others are not, inflation acts as a redistribution towards the indexed sectors away from the unindexed sectors. Again, in small amounts this is a policy choice, acting as a tax on "liquidity preference" and hoarding, rather than saving. However, beyond this amount, the effect becomes distorting, as individuals begin "investing in inflation", which, again, encourages inflationary expectations.

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Because of the above reasons for discouraging inflation above the small amounts needed to discount previous actions and discourage hoarding of currency, most Central Banks define price stability as a central goal, with a perceptible, but low, rate of inflation as the target.

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Misery index

In the 1970s a ?misery index? was proposed which equated economic unhappiness as a weighted sum of inflation and unemployment. This formula: misery = inflation % + unemployment % implied that the general population would be as unhappy about a 1% rise in monetary inflation as they would by a 1% increase in unemployment. However, modern economists have struggled to deduce such a drastically negative level of ?misery? from inflation using the mechanisms of inflation?s negative impact described above. In fact, many economists believe that the prejudice against moderate inflation in the public is an association effect, in which the public simply remember that difficult economic conditions are correlated with periods of high inflation. In this view, a moderate level of inflation is a relatively insignificant economic problem, which has been blown out of proportion by the fight against stagflation (possibly encouraged by monetarist ideology).

Related Topics:
Unemployment - Stagflation - Monetarist

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• Many economists have advocated higher rates of inflation (especially for Japan) as a solution to recession.
• Surveys on inflation consistently show a divergence of opinion between mainstream economists and the public on the damage caused by moderate inflation: While the public continue to treat the harm as severe, most monetary economists tend to see it as slight, with many saying it does no harm at all.

In opposition to the deadweight loss argument against the redistributive nature of inflation it has been argued that (because capital gains taxes are on nominal amounts) it acts as an important ?wealth tax?, and that low inflation societies will tend to see wealth condensation.

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