Our Love-Hate Relationship With Inflation

By: Joonyoung Heo

Over the past few years, there’s been more than enough inflation to go around. When the stability of market prices is often good news for the economy, and significant fluctuation is always observed carefully by the state, it’s easy to see why inflation in excess––a substantial increase of consumer prices––is a problem. Unfortunately, it’s one that looms in the present day. In the past decade, the annual inflation rate was at its lowest of 0.7 percent in 2015. It climbed somewhat to 2.1 percent in the following year, and there it hovered through 2019, relatively steady, before dropping to 1.4 percent in 2020. Then, in just 12 months, the Bureau of Labor Statistics noted a 6.8 percent increase, and on Dec. 15, the Federal Reserve acknowledged that inflation had become a major threat.

At the root of the problem are supply and demand. The COVID-19 pandemic has placed a significant burden on supply chains across the globe. Shortages, strikes, and a limited number of workers on hand have all contributed to a bottleneck of supply. Naturally, since it costs much more to produce the same goods, corporations are not going to charge the same amount of money for them––hence a sharp incline in consumer prices. On the opposite side of the spectrum, demand has also considerably increased. With pandemic restrictions loosened and much of the public vaccinated, people have generally returned to their role as consumers. Thrilled by some semblance of normalcy, even the average grocery trip has turned into a spending spree. Add that to all the stimulus checks the government has handed out in the last two years and you get high demand––and, as a result, high prices. The combination of these changes in supply and demand has largely been responsible for such skyrocketing inflation.

The danger of a 7 percent inflation rate, something the U.S. hasn’t experienced since the recessions of the early 1980s, can snowball into what economists call hyperinflation. Broadly, this is when inflation spirals out of control and continues to rise as high prices build on high prices. We’ve seen this happen in Zimbabwe, albeit in an extreme case, when President Robert Mugabe’s extractive economic institution eventually led to the collapse of the currency and the entire economy with it. It’s highly unlikely, of course, that the dollar is destined for a fate that resembles anything like its Zimbabwean counterpart, but even moderate hyperinflation causes substantial damage to the economy. It has been known to corrupt financial judgment and make essential goods unaffordable for many households. It is in the nation’s best interest to stay well away.

Despite what much of the public seems to think, however, inflation has its benefits. For one thing, a steep decrease in prices––a series of steps in the opposite direction––can lead to deflation and the general inhibition of economic activity. Clearly, a sharp half-turn may be something to avoid. But this doesn’t necessarily imply that the stagnation of prices, growth in neither direction, is good. The fact remains that a small rate of inflation is often critical to maintaining a healthy economy, for several reasons.

First, higher prices mean higher wages for workers. When everyone has more money, more money will inevitably cycle through the private sector, and when corporations have more money, they can pay higher wages to their employees. (To be clear, this doesn’t always make for higher employment, since the same wages cannot always be maintained for a greater number of people.) Those who receive more payment have more of an incentive to work, and it is a golden rule of economics that incentive is directly correlated with innovation. This leads in turn to progress, greater economic activity, and output. When there is a reward or something to work for, an individual is far more likely to perform at a higher standard. There is a reason why so many corporations have gotten rich by praising innovation with gratuity, and why the nations that only reap the fruits of the populace meet their end in economic stagnation.

Second, the paradox of thrift comes into play. The British economist John Maynard Keynes, who specialized in macroeconomics (economics of larger scale involving, for instance, the state), is mainly credited for its propagation. Essentially, the paradox argues that lower prices convince the public to limit their spending, marking balance sheets with a stringent hand, on the belief that prices will continue to drop. It’s an effect of which amateur investors will be well aware––no one has ever purchased stocks with an easy mind, after all, free from the speculation of dropping prices and the impulse of “what if”. Keynes believed that the productivity of a state could, in this sense, be to its detriment. Inversely, some degree of inflation would induce people to buy sooner rather than later, and in larger quantities, for fear that prices will begin to skyrocket. This benefits the economy by boosting aggregate demand––increased spending in the private sector––and production in the long term.

Finally, inflation makes life much easier for debtors. As market prices increase and more money is poured into the system, the value of the unit dollar decreases. That means debtors can pay what they owe with money that’s less valuable than what they borrowed. This encourages the free exchange of money and subsequently stimulates economic development. Governments are debtors, too––in fact, as of Sept. 2021, the US government is the largest debtor in the world. As with individual debtors on the “micro” scale, low inflation actually helps them pay off state debt. They can also charge higher taxes under these conditions, boosting fiscal revenue and allowing more funds to be set aside. Counterintuitive though it may seem, then, low rates of inflation might relieve some of the burden on the Federal Reserve. 

So what is the ideal rate of inflation that nations should strive for, if such a thing exists? Policymakers under the Federal Reserve set their target rate at around 2 percent, and most other sources agree. Central banks may prefer a target range from 2 to 2.5 percent. In times of recession, some economists believe that a 3 percent inflation rate would make up for the decrease in economic activity. But the consensus is there; the numbers have little to no inconsistency, and the bottom line is that it’s generally agreed by experts in the field that a small dose of inflation is crucial to run a vigorous economy.

Such is our rocky relationship with inflation. Right now, with a 7 percent rate at the close of 2021, it’s taken a serious blow in popularity. The pandemic has damaged much of the global economy and market prices have, in relativity, gone through the roof. But it’s worth keeping in mind that, someday in the future, inflation will reclaim its role as the benefactor of economics. Then, some more time later, another subversion will grip the global stage, and we will all whine and stamp our feet and banish it to the depths of condemnation. This is the way things are, and this is the way things will continue to be––until we truly understand the nuances of inflation and why we need it.