Inflation is inevitable like unemployment and is a huge concern for even countries with a robust economy. As you probably know, inflation is characterized by increased goods and services, resulting in hardship for several households, especially those with stagnant wages. While inflation is famous for its negative effects, it can also benefit an economy. But does that makes it good? Or does its negative effects on the economy makes it bad? If yes or no, why?
Inflation can be good or bad, depending on the percentage of inflation we are referring to. While a small percentage of inflation is healthy for an economy, a huge increase in inflation can devalue a country’s currency and put citizens in hardship.
Is inflation bad, or is it good? If you know the basics of inflation, you may quickly assume that it is a plague that brings only negative consequences to the economy. However, if you take a closer look at inflation, you’ll see another good side to it. In this post, I have highlighted the good and bad of inflation, then I concluded by answering the big question, “is inflation good or bad?” and of course, I gave a few reasons for the answer.
Is Inflation Good or Bad, and Why?
Whether you are a banker, an investor, an accountant, or an interior designer, you must have come across the term inflation. Of course, as a banker, accountant, or an individual working in any of the financial-related industries, you may have some insights into the term inflation. However, for those in non-financial-related industries, you may not be conversant with what inflation is, which is ok, as I have briefly explained below.
Inflation is used to describe the effects of rising oil or food prices on the economy. For instance, if the price of oil increases from $60 a barrel to $120 a barrel, input prices for businesses will rise, and transportation costs for everyone will skyrocket. The result? An increase in the prices of other goods and services.
Well, that is one definition of inflation. But you see, most economists consider the actual definition of inflation to be a little different. Inflation is a function of the supply and demand for money, meaning that producing more dollars decreases the value of each dollar, increasing prices.
How the Federal Reserve Maintains Healthy Inflation?
Like aging, inflation is inevitable. It must happen at certain points. The feds know this and are wise to draft a plan to ensure that inflation is managed. And how do they do this?
You see, the Federal Reserve has set the official inflation target at a meager 25. On August 27. 2020, the FOMC stated that it would allow a target inflation rate of over 2% if that would boost the employment rate. It’s still looking to maintain the inflation rate at 2% moving forward, but it is willing to allow higher rates if inflation has been low for a while.
That’s for the core inflation rate. It stables the prices of gas and food. It is also the year-over-year rate, not the month-to-month rate. Former Fed Chairman Ben Bernanke was the first United States Fed chair to set an inflation target.
Inflation targeting increases demand by settling an individual’s expectations about inflation. They believe the Feds will ensure prices keep increasing. That encourages them to shop now before things get very expensive.
The nation’s central bank modifies interest rates to keep inflation at around 2%. The Federal Reserve will reduce interest rates to encourage spending if inflation falls short of its target. That’s not all! The Feds will also increase interest rates if inflation surpasses their target. Inflation targeting has turned out to be an effective tool for the Federal Reserves.
To understand inflation better, we’ll be looking at some examples.
Examples of Inflation:
The housing industry offers a clear example of both inflation and deflation. Until 2006, gradually increasing prices drew investors in. Like the typical investors they are, they saw the trend as an opportunity to make profits by buying now and selling later. This led to job creation as home builders put measures in place to meet the rising demand.
Between 2006 and 2010, the housing market underwent a huge deflation. Prices plummeted by a whopping 30%. Those who lacked funds to secure a house decided to exercise patience till the market bounced back. The longer they exercised patience, the more the price plummeted.
Several people were trapped in their homes, like rabbits in a cage. They couldn’t sell their homes for enough to finance their mortgage. They became upside-down. In the end, they couldn’t see a way out. Even those who could stick with the payments often just withdrew. This made prices fall more.
Others were relying on being able to sell their home in a year or so. They were counting on this to finance a mortgage they couldn’t afford. They foreclosed and lost their precious home when they couldn’t repay their loan. Many people experienced this, which led to a glut in the market. Those who continued paying their mortgage had less money to spend on other expenses. This reduced demand in other industries. What did they get in return? A completely deflating asset.
When Inflation is Good?
When the economy isn’t performing as it should, meaning there is unutilized labor or resources, inflation theoretically helps boost production. More dollars means more spending, which equates to more demand. More demand, in turn, prompts more production to cater to the increasing demand.
British economist John Maynard Keynes believed that some inflation was required to stop the Paradox of Thrift.
So what’s the Paradox of Thrift?
The Paradox of Thrift says that if consumer prices are allowed to drop consistently because the country is becoming over-productive, consumers learn to stall their purchases to wait for an improved deal. The total effect of this paradox is to decrease aggregated demand, resulting in less production, layoffs, and a falling economy.
Inflation also benefits debtors who pay their loans with money that is less valuable than when they borrowed it. This boosts borrowing and lending, which again raises spending on all levels. Perhaps most important to the Feds is that the United States government is the biggest debtor worldwide, and inflation helps them reduce the consequences of its huge debt.
Economists once believed an admired relationship existed between inflation and unemployment and that increasing unemployment could be combated with increased inflation. The relationship was defined in the well-known Phillips curve. For those who aren’t aware, the Phillips curve was greatly refuted in the 1970s when the United States experienced stagflation.
How Close Are We to Total Economic Collapse?
When Inflation is Bad?
We have talked about when inflation is good. But when is it bad?
You see, inflation is bad when it is greater than 2%. Walking inflation is when prices increase between 2% to 10% in a year. It can boost economic growth significantly. At that point, inflation reduces the purchasing power of your money. The prices of goods and services increase more than wages. Thanks to walking inflation, it takes $24 today to buy what $1 bought in 1913.
Galloping inflation took place during the 1980s. It made President Ronald Reagan say, “Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hitman.” It took double-digit interest rates and a recession to end galloping inflation. Luckily, it hasn’t made a comeback since then and we all hope it remains that way for a long time.
One of the main reasons why inflation is yet to stage a comeback is that the Fed understands the four causes of inflation more than it did in the 1980s. It can more quickly halt rising prices by increasing interest rates.
Inflation in the U.S: Is it always bad?
Contrary to what you may think, inflation isn’t always bad news. A little bit of inflation is beneficial for an economy. If prices are decreasing, something regarded as deflation, companies may be reluctant to invest in new plants and equipment, and unemployment might increase. And inflation can make it easier for some households with higher wages to settle debts.
But, inflation, running at 9% higher, is something that hasn’t happened in the United States ever since the early 1980s. Economists believe that higher-than-normal inflation is negative for the economy for multiple reasons.
For customers, higher prices on goods like food and gasoline may affect their standard of living and quality of life, especially for those whose ages aren’t rising at all. But even when their wages are increasing, higher inflation makes it difficult for consumers to tell if a certain good is becoming more expensive compared to other goods or just in line with the average price increase. This can make it difficult for individuals to make correct budgets.
In addition to households, businesses also suffer the consequences of inflation. Businesses see the prices of important inputs like oil or microchips increase. They may want to shift the costs to consumers but could be restricted in their ability to do so. As a result, they may have to reduce production, leading to supply chain issues.
U.S Inflation: Categories Hit The Hardest:
| CPI Category | One-Year Change |
| Energy commodities | 49.5% |
| Used cars and trucks | 26.4% |
| Energy services | 11.2% |
| New vehicles | 9.8% |
| Tobacco and smoking products | 8.5% |
| Food at home | 5.4% |
| Food away from home | 5.3% |
| Transportation services | 4.5% |
| Apparel | 4.3% |
| Shelter | 3.5% |
| Alcoholic beverages | 2.2% |
| Medical care services | 1.7% |
| Medical care commodities | -0.4% |
Inflation: Good or Bad?
If you look at the definition of inflation, you may assume that it’s one of those bad situations with no benefits. However, that isn’t true. Inflation is neither good nor bad. Saying inflation is bad is like saying owning a car is bad because it increases the risk of a car accident. While saying inflation is good is like ignoring the disadvantages of owning a car, like high maintenance costs, safety issues, etc.
Inflation can be good or bad, depending on its severity. For instance, slight inflation can be used to combat issues like unemployment. When inflation rises a little, the prices of goods and services go up, thus boosting the profits of businesses. When businesses make more profit, they have the money to employ more people.
Inflation can also affect the economy negatively as the increase in prices of goods and services reduces the value of money. And who bears the brunt? Households, lots of them! So, one cannot clearly state if inflation is good or bad, as it often depends on the level of inflation in question.
Worst Investments during Inflation
What are the biggest risks of inflation?
If inflation remains high for too long, it can result in something economists refer to as hyperinflation. Hyperinflation is when beliefs that prices will continue to rise fuel inflation, which reduces the real value of every dollar in circulation. In the most extreme cases, like Zimbabwe in the late 2000s, increasing prices can collapse a currency’s value. People will want to spend the money they have immediately they get it because they are scared that prices will increase even over short periods.
The United States economy is not close to this situation, but central banks like the Feds want to prevent it no matter the costs, so they normally intervene to try and alleviate inflation before it becomes full-blown.
The Feds reduce inflation by raising interest rates, which slows the economy. Suppose the Federal reserves are forced to increase interest rates too fast. In that case, it can even result in a recession and higher unemployment, as the United States experienced in the early 1980s, around the same time inflation was this high.
The Fed chair Paul Volcker did try to control inflation from as high as about 14% in 1980, at the cost of double-digit unemployment rates. Americans aren’t experiencing inflation nearly that high, but stopping the United States from getting there is one of the goals of Jerome Powell, who currently heads the Federal Reserves.
