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).

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.

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.

Uncertainty

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 impose 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.

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.