Sometimes, Inflation Rocks
Inflation is good! This seems a rather foolhardy thing to say. It is quite hard to see why the government would want to encourage inflation instead of stable or even deflated price levels. In the past, I have tried to explain how inflation and deflation work. Nevertheless, it is worth revisiting the issue, for I think I have not made some things about inflation sufficiently clear.
Between 1986 and 2006, the value of the US dollar nearly halved — to buy what cost a hundred dollars in 1986, you would need over USD180 today. Even though economists generally agree the inflation rate has been somewhat overstated, the fact is, there has been substantial inflation.
Indeed, it would be very surprising for any developed nation not to experience inflation in a time of economic growth. As dealt with in my earlier article, deflation is an extremely undesirable state of affairs. But why would we want inflation — especially inflation as shockingly large as that which the US has apparently experienced?
The answer is growth. Believe it or not, there is a correlation between inflation and growth, both in the long and short run — albeit for different reasons.
In the short run, what would you do if you had more money in your pocket? Chances are you would spend it — at least, that's what most people would do. If the amount of money in circulation has been increased, but shopkeepers have yet to change their prices (a reasonable assumption in the short run), you will go out and buy things — and this is what will make the economy grow in the short run.
Now, what will happen in the long run? Shopkeepers will realise that the money supply has increased, so they won't be as free and easy with their prices, raising them. People stop spending, and equilibrium is restored. There is a bit of a bump from the people who took their extra money and saved it, since these savings would be invested in firms and result in long-term economic growth, but otherwise, you won't see anything interesting happen in the long run.
The real long run correlation between inflation and economic growth is that inflation is a symptom of growth. If you know your history well, you should recall that one pound sterling in the 16th century was dozens, if not hundreds of times more valuable than one pound sterling today. But would anyone in our time prefer to live in the 16th century, given the choice? The answer is simple — much of that inflation has simply arisen because the economy has grown.
We tend not to see the link between inflation and growth because we usually think of ourselves as consumers. We look at the increasingly less affordable consumer items out there and sigh — it is classic supply-side inflation. When prices of commodities we consume go up, things are bad — "aggregate supply" (the economic term for the general supply of goods and services) has gone down, meaning we have more money chasing fewer goods. Things stink.
But we never stop to think about demand-side inflation — what happens when our wages and salaries go up? Of course we're happy — but that is inflation too. When our skills are in demand, the price for our labour increases, but we acknowledge this as a good thing. The economic equivalent is when the general demand for goods and services (aggregate demand) is high — of course the economy will grow when people want to buy things. The inflationary side-effects in this case are a symptom of that growth.
It is not enough to point at the inflation rate and shriek at how things are going so badly with the economy. You must first determine what kind of inflation you are dealing with — only then can you decide whether the inflation is a sign of things going wrong, or a sign of growth.