When Is Inflation Good for the Economy?

Inflation is and has been a highly debated phenomenon in economics. Even the use of the word "inflation" has different meanings in different contexts. Many economists, businessmen, and politicians maintain that moderate inflation levels are needed to drive consumption, assuming that higher levels of spending are crucial for economic growth.

How Can Inflation Be Good For The Economy?

The Federal Reserve typically targets an annual rate of inflation for the U.S., believing that a slowly increasing price level keeps businesses profitable and prevents consumers from waiting for lower prices before making purchases. There are some, in fact, who believe that the primary function of inflation is to prevent deflation.

Others, however, argue that inflation is less important and even a net drag on the economy. Rising prices make savings harder, driving individuals to engage in riskier investment strategies to increase or even maintain their wealth. Some claim that inflation benefits some businesses or individuals at the expense of most others.

The Federal Reserve targets a 2% annual inflation rate, believing slow and steady price increases help keep businesses profitable.

Understanding Inflation

Inflation is often used to describe the impact of rising oil or food prices on the economy. For example, if the price of oil goes from $75 a barrel to $100 a barrel, input prices for businesses will increase and transportation costs for everyone will also increase. This may cause many other prices to rise in response.

However, most economists consider the actual definition of inflation to be slightly different. Inflation is a function of the supply and demand for money, meaning that producing relatively more dollars causes each dollar to become less valuable, forcing the general price level to rise.

Key Takeaways

• Inflation, in the basic sense, is a rise in price levels.
• Economists believe inflation comes about when the supply of money is greater than the demand for money.  
• Inflation is viewed as a positive when it helps boost consumer demand and consumption, driving economic growth.
• Some believe inflation is meant to keep deflation in check, while others think inflation is a drag on the economy.
• John Maynard Keynes said that some inflation helps prevent the Paradox of Thrift—delayed consumption.

When Inflation Is Good

When the economy is not running at capacity, meaning there is unused labor or resources, inflation theoretically helps increase production. More dollars translates to more spending, which equates to more aggregated demand. More demand, in turn, triggers more production to meet that demand.

British economist John Maynard Keynes believed that some inflation was necessary to prevent the Paradox of Thrift. Which says, if consumer prices are allowed to fall consistently because the country is becoming too productive, consumers learn to hold off their purchases to wait for a better deal. The net effect of this paradox is to reduce aggregate demand, leading to less production, layoffs, and a faltering economy.

Inflation also makes it easier on debtors, who repay their loans with money that is less valuable than the money they borrowed. This encourages borrowing and lending, which again increases spending on all levels. Perhaps most important to the Federal Reserve is that the U.S. government is the largest debtor in the world, and inflation helps soften the blow of its massive debt.

Economists once believed an inverse relationship existed between inflation and unemployment, and that rising unemployment could be fought with increased inflation. This relationship was defined in the famous Phillips curve. The Phillips curve was largely discredited in the 1970s when the U.S. experienced stagflation.

 

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