Question

How does inflation stimulate the economy? What effect does inflation have on wages? Why is too much inflation bad?

Answer 1

Inflation is good if moderate. There are two cases in which this occurs. The first is when inflation is leading customers to expect prices to keep rising. If prices go up, people will buy more now instead of paying later. In the short term, that increases demand. As a result, stores are selling more and now factories are making more. In order to meet demand, they are more likely to hire new workers. It creates a virtuous cycle which stimulates economic growth.

The second is, when the risk of deflation is eliminated. That is when the prices go down. When that happens, people wait to see if prices drop further before buying. It is cutting competition, and businesses are rising their inventory. As a result, factories are making fewer and laying off workers. Unemployment is increasing, which results in wage deflation. Workers have less money to spend, which further reduces competition. The firms are lowering their costs. That exacerbates deflation. That is why deflation makes economic growth even more corrosive than inflation.

The Federal Reserve has set the official inflation target for the core inflation rate at 2 per cent.1 That is. This cuts off high food and gas prices. It is also the average of the year over the year, not the rate of the month to the month. The first U.S. president was former Fed chairman Ben Bernanke. Fed chair to set a target for inflation. Inflation targeting demand spurs by setting inflation expectations for the population. They assume the Fed will see to it that prices continue to rise. Which encourages them to shop now before prices go up even further. The central bank of the country adjusts interest rates to sustain inflation at about 2%. When inflation does not reach its target, the Fed would lower interest rates to boost the lending.

Inflation increases capital costs, making it harder for the capital to substitute when it wears out. It also chases capital away into a more stable currency; i.e., somewhere with less inflation. And if we pair inflation with high government taxes so excessive spending, then we get capital consumption / destruction. It, too, reduces over time productivity and salaries. Imagine what it would be like if road crews were to use shovels and picks as opposed to large earth-moving gear. Over time we could see those days again if we kill enough resources or have enough wealth-destroying inflation.

Some people find it more convenient to' retire' and seek employment in the underground economy (working for cash) when wages no longer keep up with inflation. While this may be illegal in some cases (if they don't declare their cash income or receive more than permitted by law), more people may follow this path as times get tougher. In short, inflation is driving people into the underground economy to avoid the malfunctions of money-printing and heavy taxation by government.

If inflation reaches 2 per cent, then it becomes risky. Inflation walking is when prices rise in a year from 3 to 10 per cent. This can drive too much growth in the economy. Inflation at that point robs you of your hard-earned dollars. Every day the prices of items that you buy rise faster than the wages. Due to walking inflation, buying what $1 did in 1913 costs $24 today. Inflation was galloping during the 1980's. This led President Ronald Reagan to say famously, "Inflation is as brutal as a mugger, as threatening as an armed robber, and as dangerous as a hit man." To avoid galloping inflation, this took double-digit interest rates and a recession.