Why Moderate Inflation is a good thing

By Prakhar Misra

Inflation is not always bad for the economy. Some amount of inflation can aid the growth of an economy.

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In economics and in public discourse, inflation is a highly debated term spurring very extreme emotional responses. The media reports tend to suggest, albeit subtly, that inflation is a bad thing and that rising inflation is a cause of concern that needs to be dealt with immediately.

However, that is not true. Inflation, like all other Economic concepts is one that is beneficial if maintained in balance. Too high or too low inflation can be problematic. The costs of a deflationary economy are all too clearly seen in Europe now and in Japan since the 1990s.

Inflation is basically a resultant of supply and demand of money in relation to the amount of goods and services produced in an economy. If there is more money, the value of each unit of the currency is reduced. So, it makes the currency less valuable in effect causing a rise in price. But, there is a general consensus that some amount of moderate inflation in healthy for the Economy.

The first caveat of this wisdom lies in John Maynard Keynes’ description of “Paradox of thrift”. Keynes talked about this paradox with respect to savings rate and one way to go around it was to have some positive inflation. If there is no inflation and prices keep reducing, then individuals will keep delaying their spending which will lead to a fall in aggregate demand resulting in less production, layoffs and hence a decline in Economic growth. Hence, having a positive inflation rate helps in preventing such a situation.

In theory, inflation also helps in increasing production. More money means more spending which further translates to an increase in aggregate demand. This increase feeds into increasing production of goods in the country.  Infact, the Phillips Curves showed that by increasing inflation, we can successfully bring down unemployment levels. Although the 1970s era of ‘stagflation’ successfully rebutted this claim- but it was in the minds of many until then.

Higher inflation would lead to a price rise which would push companies to raise wages too. This might not be by full effect of inflation, but some sort of a rise can be expected. Thus, the rise in prices is more than the rise in wages as revision of wages takes time due to rewriting of contracts. This leads to an increase in the income of the firm which in turn helps in reducing the debt on loans and mortgages, effectively benefitting companies.

Inflation also helps governments reduce its debt burdens in 2 ways.Firstly, a healthy dose of inflation in the economy helps governments to collect more taxes. Even if the economy is stagnant, as long as there is inflation- the revenues of the government would continue to increase. Thus, even though inflation may devalue the currency – it may be offset by the excess money coming into the system that can be used to invest, build, hire more staff and spend in other areas of boosting economic activity. Secondly, the debt owed by governments to its lenders is not indexed to inflation. Thus, a higher rate of inflation reduces the value of the government’s debt, assisting the government in effectively paying back a lesser value than what it would otherwise.

But, all of these benefits are to inflation only if it is administered in moderation. Unless interest rates are higher than inflation rate, too much inflation leads to an inflationary spiral. Because of high prices- the profits of a company rise and so they hire more workers and increase wages. So, now goods are priced higher and people have more money to spend- and this leads to a successive increase in price rise. So, prices keep rising, but we don’t receive any benefit for our excess money. A deflationary spiral is equally dangerous, if not more. Prices reduce and people spend less because they delay their spending in expectation of prices to reduce further. This leads to companies laying off workers and cutting costs which further leads to a price-cut and so on.

For the first time in 2015, a Monetary Policy Framework was signed between the RBI and the Government of India which categorically states the following with respect to inflation: “The target for financial year 2016-17 and all subsequent years shall be 4% +/- a band of 2%.”

The target for January 2016, from the MPF, was to bring Inflation below 6% and the RBI has succeeded in doing that. Although, some Economists argue that even 5% is too high for India given that many countries in the world are hovering between 1-3% inflation rate.

A 3% inflation rate is generally accepted to be ideal, i.e, pushing a country to economic growth and preventing it from sliding into recession. While the inflation target of USA is set at 2%, countries like Zimbabwe had an inflation rate of 231 million % until very recently. So, Inflation can go either way depending on how well it is managed.

As the Austrian philosopher and economist Ludwig Von Mises said, “The most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague, inflation is a policy.”

Prakhar Misra is a Chanakya Scholar at the Meghnad Desai Academy of Economics. He is an Alumnus from the GCPP. He tweets @prakharmisra .

 

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