18 Inflation
Inflation is a topic that often catches our attention, whether through news headlines or personal experiences. You might notice it when the price of everyday essentials like eggs or bread increases, yet your income remains the same. If your hourly wage or earnings no longer allow you to buy as many goods and services as you could a year ago, it’s natural to feel dissatisfied. This erosion of purchasing power is the effect of inflation.
Inflation became a major concern globally following the COVID-19 pandemic. Many households felt its impact directly, as prices rose while incomes often lagged behind. This brings us to an important question: should we aim for zero inflation? Surprisingly, the answer is no. Instead, most central banks target an inflation rate of around 2%. This moderate level is considered healthy for the economy, providing stability while allowing prices to adjust.
However, inflation becomes a concern if it falls below 1% or rises above 3%, as both extremes can cause economic challenges. Striking the right balance is crucial for maintaining economic growth and protecting the purchasing power of individuals.
We don’t aim for zero inflation because moderate inflation, such as the 2% target set by many central banks, serves several important economic purposes. Zero inflation increases the risk of deflation, where falling prices can harm the economy by encouraging consumers and businesses to delay spending and investment. This leads to reduced economic activity, lower wages, and higher unemployment. An example of this occurred during the Great Depression of the 1930s. In that period, prices fell sharply, leading to deflation. As prices dropped, consumers and businesses delayed purchases and investments, expecting prices to fall even further. This behaviour created a vicious cycle: reduced spending led to lower revenues for businesses, which in turn caused layoffs and wage cuts. As unemployment rose, demand dropped further, deepening the economic downturn.
A more recent example is Japan’s “Lost Decade” in the 1990s and 2000s. During this time, Japan experienced near-zero or negative inflation, leading to persistent deflation. Consumers delayed spending, businesses hesitated to invest, and the economy stagnated for years. This shows how zero inflation can create conditions ripe for deflation, with significant negative consequences for economic activity and employment.
Inflation also helps reduce the real burden of debt over time. Without inflation, the real value of debt remains unchanged, discouraging borrowing and investment, which can slow down economic growth. A good example of how inflation reduces the real burden of debt can be seen in the post-World War II period in many advanced economies. During the 1950s and 1960s, countries like the United States and the United Kingdom had relatively high levels of government debt due to wartime spending. However, moderate inflation during this period helped erode the real value of that debt. As nominal GDP grew (partly due to inflation), the debt-to-GDP ratios declined significantly, even without drastic spending cuts or tax increases.
For individual borrowers, consider a homeowner with a fixed-rate mortgage. If inflation rises moderately, their nominal wages tend to increase over time, but the monthly mortgage payment stays the same in nominal terms. As a result, the real burden of the mortgage payment (how much it costs in terms of purchasing power) decreases. Without inflation, this erosion of the debt burden doesn’t occur, making loans more expensive in real terms and discouraging borrowing and investment.
Additionally, workers tend to resist nominal wage cuts, even during economic downturns. Moderate inflation allows real wages to adjust downward without requiring nominal wage reductions, helping to maintain employment levels. A clear example of how inflation helps adjust real wages without nominal wage cuts can be seen during the aftermath of the 2008 Global Financial Crisis. In many advanced economies, such as the United States and the UK, unemployment rose sharply, and businesses faced pressure to cut costs. However, rather than reducing nominal wages, which often leads to strong resistance from workers, many firms chose to freeze wages while inflation eroded their real value over time.
For instance, if inflation is 2% and a worker’s salary remains unchanged, the real purchasing power of that salary effectively decreases by 2% over a year. This adjustment helps employers reduce labour costs without sparking morale issues or employee unrest that might occur with outright wage cuts. Without moderate inflation, companies would have had to pursue nominal wage cuts more frequently, which could lead to greater conflicts, reduced productivity, or even layoffs, ultimately exacerbating unemployment during the downturn.
Targeting 2% inflation specifically provides a cushion against deflation, reducing the risk of slipping into harmful deflationary periods during economic downturns. It also gives central banks room for monetary policy actions, as positive inflation allows interest rates to be lowered when necessary. At zero inflation, nominal interest rates approach zero, limiting central banks’ ability to stimulate the economy – a problem known as the zero lower bound.
Moderate inflation also encourages spending and investment, as people and businesses are incentivised to act sooner rather than later, knowing that money will gradually lose its purchasing power. Furthermore, a consistent 2% target promotes economic stability by offering predictability, which fosters confidence in long-term planning and contracts. Over time, economists have found that 2% inflation strikes a good balance, minimising the risks of deflation while supporting stable economic growth, employment, and manageable debt dynamics. This makes it the widely accepted standard for central banks worldwide.
