According to much popular mainstream economic thinking, the policy of so-called “price stability” does not always mean that the central bank must fight inflation. It is also the role of the central bank to prevent large declines in the inflation rate or an outright decline in general “price level.” Why is that so?
A decline in the price level—called deflation—allegedly weakens consumer and business expenditure thereby paralyzing economic activity. Furthermore, a decline in the pace of increase in the prices of goods and services raises the real interest rates thereby further weakening the economy. Additionally, as spending weakens, this further raises unutilized capacity and puts additional downward pressure on the price level.
Most economists believe that it is much harder for the central bank to handle deflation than inflation. When inflation rises, the central bank can always supposedly “cool it off” by large increases in interest rates. Regarding deflation, the lowest percentage that the central bank can go is the zero-interest rate. Below this percentage, individuals are likely to be reluctant to lend. According to popular thinking, the real interest rate is defined as the nominal interest rate minus the inflation rate. From this, one can also establish that: the nominal interest rate equals real interest rate plus the inflation rate.
Let us say that, as a result of a decline in the inflation rate from 1 percent to -1 percent, central bank policymakers have concluded that a real interest rate of -0.5 percent is required to counter deflation thereby preventing an economic deterioration. At an inflation rate of -1 percent, this would require the central bank to lower the nominal interest rate to -1.5 percent. Since this is below zero, individuals are likely to be reluctant to lend.
Likewise, when the inflation rate is very low it can also create problems. Suppose that inflation has fallen from 2 percent to 1 percent. At a nominal rate of 0 percent, the central bank can set a target for a real interest rate of -1 percent. It cannot aim at a lower real interest rate since this would imply setting the nominal interest rate to below zero. As the economy weakens further and the inflation rate falls to 0.5 percent this will not allow the central bank to target real interest rates to below -0.5 percent.
According to such thought, a low inflation rate, or outright deflation, reduces the central bank’s ability to revive the economy. Hence, the policy of so-called “price stability” must aim at a certain level of inflation, which will give the central bank the flexibility to keep the economy on the path of economic prosperity and prevent the economy declining into deflation. The essence of all this is that inflation is necessary in order to have economic prosperity and stability. The inflationary buffer must be large enough to enable the Fed to maneuver the economy away from the danger of deflation. Mainstream economists hold that an inflation rate around 2 percent is not harmful to economic growth. They are of the view that the inflation rate of 2 percent seems to be good for the economy, a higher inflation rate—say, 10 percent—could be actually bad.
Why would an inflation rate of 10 percent or higher be regarded as bad? If anything, at an inflation rate of 10 percent, consumers are likely to form rising “inflation expectations” and, in response to a high inflation rate, consumers will increase their spending on present goods, which should boost economic growth.
Inflation Is Not Increasing Prices
Inflation is not about general increases in prices as such, but about increases in the money supply. As a rule, an artificial increase in money supply sets in motion general increases in prices. This, however, need not always be the case. The monetary price of a good is the amount of money asked per unit of it. Given an unchanged quantity of money and an expanding quantity of goods, prices will actually decline. The reason why inflation is bad news is not because of increases in prices as such, but because of the damage inflation inflicts to the wealth-formation process. Here is how.
The chief role of money is to fulfill the role of the general medium of exchange. Money enables individuals to exchange something they have for something they prefer more. Before an exchange can take place, individuals must have something useful that can be exchanged for money. Once they secure the money, they could then exchange it for the goods they want in the present or the future.
Now, consider a situation in which money is generated out of “thin air.” This new money is not different from counterfeit money. The counterfeiter exchanges the fraudulent money for goods without producing anything useful. He exchanges nothing for something. He expropriates the production of others through fraud without adding any valued production. This impoverishes the honest, savers, and wealth-generators.
The inflated money diverts wealth towards the holders of new money. This weakens the wealth-generator’s ability to generate wealth and this, in turn, leads to a weakening of economic growth. As a result of the artificial increase of the money supply, what we have here is more money per unit of goods, and thus, higher prices, all other things being equal. What matters is “the counterfeiter effect.” Therefore, anything that promotes artificial increases in the money supply can only make things much worse. Obviously then, countering a declining growth rate of prices by means of an easy monetary policy (i.e., by generating inflation) is bad news for the process of wealth-generation, and hence, for the economy.
Furthermore, if a decline in prices emerges on the back of the collapse of non-productive bubble activities in response to soft monetary growth, then this should be seen as good news. The less non-productive bubble activities, the better it is for the wealth-generators and economic growth overall. If prices decline because of a market expansion of goods, then this is great news. Hence, contrary to the popular view, a decrease in the growth rate of prices is good news for the wealth-generating process and hence for the economy. According to Joseph Salerno,
…historically, the natural tendency in the industrial market economy under a commodity money such as gold has been for general prices to persistently decline as ongoing capital accumulation and advances in industrial techniques led to a continual expansion in the supplies of goods. Thus, throughout the nineteenth century and up until the First World War, a mild deflationary trend prevailed in the industrialized nations as rapid growth in the supplies of goods outpaced the gradual growth in the money supply that occurred under the classical gold standard. For example, in the US from 1880 to 1896, the wholesale price level fell by about 30 percent, or by 1.75% per year, while real income rose by about 85 percent, or around 5 percent per year.
Conclusion
A policy of generating inflation in order to enable central bank policy makers to guide economic growth leads to boom-bust cycles and economic impoverishment. The emergence of deflation is always good news since it is in response to the liquidation of various activities that cause the erosion of the wealth-generation process.
