I’m publishing this comment as a post because I’d forgotten about the effects of inflation on wages – a phenomenon that I haven’t read elsewhere recently - and partly because I’d like someone to answer the question not answered here, namely, what are the advantages of deflation or zero growth? I also like the notion that in Britain we send an ‘open letter’ to the Bank of England when things get sticky, whereas in New Zealand, someone gets sacked. More big-brain stuff, please. John J Kelly
Inflation is a handy device for stealthily lowering wages, while deflation makes money cheaper but discourages both risk-taking and saving. By Adam Keats.
Few would debate that it is preferable to have a small amount of inflation (see Michael Prescott’s comment, Thus passim). The real debate is whether policy makers should veer on the side of caution of push for growth if faced with the choice (dove/hawk argument). Most of the literature on this focuses on inherent bias that the monetary policy actor exercises short term opportunism to stimulate the economy at the expense of a higher inflation rate in the long term. Hence a lot of the debate focuses on the desirability of creating systems to increase the penalties to policy makers for overshooting targets, such as the open letter system in the UK. The 1989 New Zealand Reserve Bank Act explicitly links monetary policy to inflation, and I believe they have a system that actually fires the head of the central bank in the event of inflation overshooting agreed targets. The US approach is slightly different in nominating long term Chairmanship of the Fed to encourage compliance with agreed inflation-limiting targets.
Arguments against deflation
The 0% nominal interest rate floor provides the strongest barrier against inflation, but carries the risk that a situation of prolonged deflation, similar to Japan’s 10 year slump of the 1990s. If deflation occurs then the real interest rate is positive even when nominal interest rates are 0%. From a theoretical point of view this means that the cost of borrowing rises – in other words, the opposite to what is wanted in a deflationary environment. This cycle becomes extremely difficult to escape. The current UK and US situation is, however, less risky. The culture in Japan is very different – in my opinion the risk appetite is extremely low – differing from the US and UK. This meant that it led to a rapid fall in demand for money even at 0%. Furthermore, when the opportunity cost of holding money in a bank is 0%, people hold onto more cash rather than invest it (especially if the banking system itself seems unstable) so savings demand dries up.
Arguments against inflation
The inflationary spiral is an obvious prime consideration. Increases in the supply of a good decreases its price. Inflation is a fall in the value of money. Printing money, regardless of supply and demand arguments, will lead to inflation – this is the basic essence of monetarism. The less obvious part of the argument is why does inflation spiral even when the printing of money stops in the long run and when does it reach the point of no return? Money is essentially a medium of exchange and thus fiat money (money which has no inherent value) derives its value as a medium of exchange. Inflation in this sense causes fluctuations in the value of this ‘medium for exchange’ and thus its only real advantage over a bargaining system. The value of money therefore falls (remember that a rise in inflation is a fall in the value of money, the same relationship applies the other direction). This leads to more inflation. Hyperinflation can be thought of as the point at which the value of money is declining so rapidly that it fosters its own decline. Examples are the current situation in Zimbabwe or historically, in interwar Germany. Inflation has plenty of other practical costs – all pretty standard textbook ones – such as ‘menu costs’ (the cost and labour of rewriting menus and repricing in general) and ‘shoe-leather costs’ (the cost of comparing less stable prices) etc. Most serious is the real fall in the value of savings, although this can be mitigated provided interest rates rise in line with inflation. Another problem is that domestically-produced goods become uncompetitively priced.
Advantages of Inflation
The strongest argument is that inflation mitigates against price rigidities in the labour market. Workers over-emphasize nominal wage changes. It is very difficult to lower someone’s nominal pay, but easy to increase it. Hence this causes labour prices to be strongly ‘sticky downward’ (reluctant to drop). Inflation helps to overcome this. By increasing workers pay at a below inflation rate the real wage can be lowered without having to lower nominal wages. In this sense, slight inflation helps to ease real price rigidities in the economy.
