Inflation erodes the value of real currency
ECONOMISTS tend to favour a small positive rate of inflation, and there are 4 reasons why this makes sense:
- Labour market flexibility: inflation allows relative real wages to adjust even if nominal wages do not move. A company that tries to pay workers less money is likely to meet with resistance. Disputes over wages can distract business leaders from strategic priorities and lead to strikes and industrial action. Most recently, Qantas grounded its entire domestic and international fleet due to widespread industrial action. While it may be difficult for a company to reduce worker pay, inflation can improve labour market flexibility by reducing the real wage of any worker whose nominal wage does not keep pace with inflation.
- Avoiding the liquidity trap: central banks normally conduct monetary policy by controlling short term interest rates. Where interest rates are zero, or near zero, a central bank will not be able to stimulate the economy by lowering interest rates further (the liquidity trap). A moderate level of inflation helps to avoid the liquidity trap. For example, if inflation were 3% then a central bank could set the real short term interest rate at 0% by lowering the nominal short term interest rate to around 3%.
- Investment in physical capital: moderate inflation encourages businesses to invest in physical capital (e.g. plant, property, equipment and inventory) instead of holding investments denominated in dollars (e.g. cash or bonds).
- Avoiding “the deflation”: If people expect prices to fall then they are likely to hoard money and delay consumption. A widespread expectation of deflation is likely to be self-fulfilling, and reduced consumption would depress the economy.
For all its good deeds, inflation does have blood on its hands.
Inflation killed the penny.