Alex Fatuliaj
January 8, 2024
Macro Monday

There is some debate about whether a low inflation target is the best policy a country can take. To analyse this, we need to understand inflation, its causes, its benefits, and its drawbacks. But, given this topic is incredibly deep, the best we can do is give an overarching assessment.

What is inflation


An increase in prices of goods and services. Traditional economics looks at inflation from the perspective of the price, not from the perspective of the quantity of assets (in this case fiat currency) like we do in crypto. This distinction is very important because inflation of prices doesn’t necessarily only happen when the money supply increases.

What causes inflation


There are a few reasons, but the 4 most occurring ones are below:

  1. An increase in the money supply.
  2. A depreciation in currency value.
  3. Aggregate demand (AD) shifts right - population growth, technology innovation, etc.
  4. Aggregate supply (AS) shifts left - higher production costs, weather, disasters, etc.

As you can see here, inflation can be caused by “good” or “bad” factors, but the reason behind why it’s happening is separately good or bad. Let’s explore a bit further.

  1. An increase in the money supply is basically the government enacting quantitative easing or printing more money, and no, the two are not the same. This can be happening due to the government needing to boost the economy, pay off its debts, or give itself more spending power - so, fundamentally, not particularly great causes, but can create more benefits.

  2. A currency depreciation can happen due to many reasons, but at its core, it’s either due to an increase in supply (as mentioned above), or a decrease in demand. Regarding the latter, it happens if entities abroad buy less of this currency either due to a domestic reduction in imports or because they don’t want to save as much wealth in this country’s banks.


    This causes inflation in two ways: cheaper currency makes imports more expensive which increases prices domestically, and the flip side - cheaper currency makes exports more competitive, which yields domestic companies greater revenue allowing them to increase prices.

  3. AD shifting to the right is a good thing - it implies the economy is growing one way or another: higher employment, increase in GDP per capita, etc. More demand = higher prices.

  4. AS shifting left isn’t a particularly good thing on the other hand, as it implies an increase in prices out of need, not want. Generally, this happens due to higher production costs or macro factors that impact production in the economy negatively. But, in some cases, such as the introduction of a national minimum wage, the underlying cause of a decrease in AS is arguably beneficial.

Now that we have a rough understanding of what causes inflation, and how the underlying reasons could either be good or bad, let’s look at inflation itself.

Benefits of inflation


Incentivised spending


If the value of your money is eroding you’re incentivised to spend it in the economy rather than save it: more money flows from people to businesses, businesses to businesses, and businesses to people. Generally speaking, a lot of these processes are taxed, which also boosts the government’s budget and increases reinvestment into things like infrastructure, which boosts the economy further.

However, you’re also incentivised to move the money abroad, which leaks the value of the economy and, thus, isn’t great.

Employment benefits


The relationship between inflation and unemployment, conceptualized in the Phillips Curve, suggests that some inflation can be beneficial for employment. As businesses see prices for their products rise, they often experience higher profits and can afford to hire more workers. This relationship indicates that a completely inflation-free environment might not always be ideal for maximizing employment.

And yes, the curve breaks past the X axis, because if the country hits deflation, unemployment is likely to rise due to less spending and the subsequent less revenue for businesses.

Debt management


If, for example, you were $33 Trillion in debt (this is a hypothetical example, no country is that much in debt 😐️), inflation can play a role in easing debt burdens; when prices rise, the real value of debt diminishes. This effect can be particularly beneficial for governments and businesses with significant outstanding debts. It also incentivises people (particularly entrepreneurs) to borrow more, knowing that the value of their debt will diminish.

By reducing the real burden of debt and its corresponding interest repayments, inflation can provide breathing room for debtors, enabling them to allocate resources to other areas like investment and development.

Deflation avoidance


Inflation serves as a bulwark against deflation – a scenario often more detrimental than moderate inflation. Deflation can lead to a decrease in consumer spending, as people delay purchases in anticipation of even lower prices. This reduced spending can spiral into lower production, increased unemployment, and a general economic slowdown.

However, it seems that the cause of the deflation is crucial in assessing whether it’s a cause for concern, as it can be caused by improvements in domestic production, facilitating lower prices.

Drawbacks of inflation


Erosion of purchasing power


A primary concern with inflation is the erosion of purchasing power. As prices rise, each unit of currency buys fewer goods and services. This impact is most acutely felt by those with fixed incomes, such as retirees, whose income does not increase with inflation. It disproportionately affects lower-income households, which spend a larger portion of their income on necessities. For them, even modest inflation can lead to financial strain.

Moreover, unfortunately, wages often lag behind inflation, meaning the real wages of people are constantly diminishing.

Income Redistribution Effects


Inflation can act as a regressive tax, disproportionately impacting the poor. Those with assets that appreciate in value (like property or stocks) can keep pace with or even benefit from inflation. In contrast, those without these assets or with fixed incomes find their purchasing power significantly reduced.

Hyperinflation Risks


When left unchecked, inflation can escalate into hyperinflation, causing rapid and uncontrollable price increases. This scenario can lead to severe economic disarray, as is particularly witnessed by Zimbabwe and Argentina currently.

Overall


We need to separate inflation caused by government intervention vs inflation caused by natural causes.

Regarding inflation created by the government, in a Keynesian framework, a certain level of it as a tool for economic growth is justified because the increased spending and overall activity can boost the economy. But, from Friedman's monetarist perspective, any attempt to use inflation as a tool for economic management, including boosting exports, is inherently flawed. Friedman famously stated, "Inflation is always and everywhere a monetary phenomenon," arguing that inflation results from too much money chasing too few goods. He would caution against using inflation to gain short-term advantages, emphasizing the long-term stability offered by steady monetary growth.

Regarding natural inflation, it is merely the subsequent of aggregate demand and supply, so its benefit or detriment shouldn’t be assessed without the context of its cause; said cause is what we should look at to assess economic health.


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