Is moderate inflation good for the economy?
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Originally Answered: Is inflation good for the economy?
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Originally Answered: How can inflation be healthy for an economy?
Basically every answer to this question has captured part of the story, so this answer will be partially redundant. However, I didn't see the first few answers mention what I think is the most important benefit conferred by inflation
1. Ameliorates Nominal Wage Rigidity - During periods of economic stagnation or contraction (recessions/depressions), the value contributed by workers declines. To be a bit wonkish, the marginal productivity of labor falls. A given firm's level of employment will be based on an optimal quantity of labor determined largely by the marginal productivity of additional labor. So when that productivity falls, it will be rational for the firm to adjust its payrolls to reflect reduced demand for labor. Unfortunately, the firm will usually choose to cut 20% of its workers rather than to cut each of their salaries by 20%. This is really a matter of culture and the social stigma of pay cuts more than anything else. A more sensible approach would be for each worker's wages to decline proportionately to their fallen productivity/decreased contribution to profitability. Inflation makes an effective decline in wages possible, because while pay cuts are widely unpopular, pay freezes are commonplace during recessions. Through pay freezes and the erosion of wages by inflation, an employer will be compelled to fire fewer workers. This is better for the economy than some workers retaining their yearly raises while they pay extra through taxes for unemployment benefits for their former co-workers, who now are not contributing to economic output.
2. Upward Pressure on Monetary Velocity - During the aftermath of the financial crisis of 2007 and 2008 in the US, monetary velocity fell significantly:
![]()
This basically means that money was moving around the economy more slowly. Businesses were waiting to invest internally, so they sat on their profits. Individuals lucky enough to have money in their savings were reluctant to spend it, because they were afraid to invest and/or they felt that they were at risk of a financial emergency, during which they would need to rely upon liquid savings.
Inflation discourages stagnant money. Companies become a bit less likely to sit on their money if it is devaluing at 4% per year rather than 1% per year. So instead they will invest, usually resulting in increased employment. Increased employment is good. For the individuals with their savings, inflation will be a nudge to put that money "to work," by investing or buying a new car or remodeling their home, etc. This promotes employment as well.
3. MOST SIGNIFICANT: Permits Negative Effective Interest Rates - I'll first provide some background for those unfamiliar with monetary policy. During times of sluggish economic growth or economic contraction, the typical response from a central bank is to pursue expansionary monetary policy. The most conventional way for a central bank to do this is to cut interest rates. One way of modeling an appropriate interest rate adjustment is by using the Taylor Rule, explained below.
![]()
Basically the larger the gap between the economy's total output and its potential output, the lower interest rates will need to be set to remedy this gap. The rule is also relevant for cases of high inflation and a negative output gap, or the economy performing beyond its theoretical potential. In these instances, the rule would call for an increase in interest rates. The Taylor Rule has its a and b constants that can be raised or lowered from 0 to 1 to produce a more hawkish or dovish central bank response.
But recently the ability of central banks to fight economic crises has been handicapped. Due to a decline in the natural rate of interest (a subject worthy of its own Quora answer), economic conditions have reached a point where the appropriate central bank response is to set a negative effective interest rate. Plugging in the appropriate variables for much of the developed world will produce a Taylor Rule-determined interest rate that is below zero. This is demonstrated in the graph below: the federal funds rate is stuck near zero, while the Taylor Rule would imply that more stimulative policies (i.e. a negative effective interest rate) are desirable.
![]()
Unfortunately, central banks do not really have the power to do this; as soon as the rate they set becomes negative, then holding money in banks will result in declining rather than increasing balances. So a negative nominal rate will drive people to withdraw their money and, in layman's terms, stick it in their mattresses.
But many economists believe that a cure can be provided by moderate levels of inflation. Since it is only the nominal interest rate affected by the zero lower bound, effective (or inflation-adjusted) interest rates are still capable of falling below zero in accordance with the Taylor Rule's recommendations. A nominal central bank interest rate of 0.25%, as we currently have in the US, is the equivalent of a -0.75% rate with our inflation at about 1%. If inflation was 4%, however, the Federal Reserve would have a lot more flexibility to act in accordance with the Taylor Rule. The lowest possible nominal rate, which is essentially 0.25%, would be the equivalent of a particularly stimulatory effective rate of -3.75%.
The rate that the Taylor Rule calls for has fallen lower with each recession. As I mentioned above, I believe that this is due to a decline in the natural rate of interest, driven by a variety of factors. This has been referred to by some as secular stagnation. For now, the zero lower bound has declined in relevance. The US and Europe are recovering and before long the Fed and the ECB will be in position to raise interest rates. But don't expect the previously normal rates of the late 90's at around 5%. Instead, we'll probably creep back up to 1.5% before the next recession hits. At that point, the rate needed to respond effectively will be even lower. We can respond to that next crisis the way we responded to this one, by having our recovery held back by an insufficient response of monetary policy, or we can act to alleviate the suffering of millions and respond to needlessly high unemployment rates, by pursuing inflation targets closer to 4%. A higher inflation target will safeguard against recessions by enabling a stronger response from central banks.
1. Ameliorates Nominal Wage Rigidity - During periods of economic stagnation or contraction (recessions/depressions), the value contributed by workers declines. To be a bit wonkish, the marginal productivity of labor falls. A given firm's level of employment will be based on an optimal quantity of labor determined largely by the marginal productivity of additional labor. So when that productivity falls, it will be rational for the firm to adjust its payrolls to reflect reduced demand for labor. Unfortunately, the firm will usually choose to cut 20% of its workers rather than to cut each of their salaries by 20%. This is really a matter of culture and the social stigma of pay cuts more than anything else. A more sensible approach would be for each worker's wages to decline proportionately to their fallen productivity/decreased contribution to profitability. Inflation makes an effective decline in wages possible, because while pay cuts are widely unpopular, pay freezes are commonplace during recessions. Through pay freezes and the erosion of wages by inflation, an employer will be compelled to fire fewer workers. This is better for the economy than some workers retaining their yearly raises while they pay extra through taxes for unemployment benefits for their former co-workers, who now are not contributing to economic output.
2. Upward Pressure on Monetary Velocity - During the aftermath of the financial crisis of 2007 and 2008 in the US, monetary velocity fell significantly:
This basically means that money was moving around the economy more slowly. Businesses were waiting to invest internally, so they sat on their profits. Individuals lucky enough to have money in their savings were reluctant to spend it, because they were afraid to invest and/or they felt that they were at risk of a financial emergency, during which they would need to rely upon liquid savings.
Inflation discourages stagnant money. Companies become a bit less likely to sit on their money if it is devaluing at 4% per year rather than 1% per year. So instead they will invest, usually resulting in increased employment. Increased employment is good. For the individuals with their savings, inflation will be a nudge to put that money "to work," by investing or buying a new car or remodeling their home, etc. This promotes employment as well.
3. MOST SIGNIFICANT: Permits Negative Effective Interest Rates - I'll first provide some background for those unfamiliar with monetary policy. During times of sluggish economic growth or economic contraction, the typical response from a central bank is to pursue expansionary monetary policy. The most conventional way for a central bank to do this is to cut interest rates. One way of modeling an appropriate interest rate adjustment is by using the Taylor Rule, explained below.
Basically the larger the gap between the economy's total output and its potential output, the lower interest rates will need to be set to remedy this gap. The rule is also relevant for cases of high inflation and a negative output gap, or the economy performing beyond its theoretical potential. In these instances, the rule would call for an increase in interest rates. The Taylor Rule has its a and b constants that can be raised or lowered from 0 to 1 to produce a more hawkish or dovish central bank response.
But recently the ability of central banks to fight economic crises has been handicapped. Due to a decline in the natural rate of interest (a subject worthy of its own Quora answer), economic conditions have reached a point where the appropriate central bank response is to set a negative effective interest rate. Plugging in the appropriate variables for much of the developed world will produce a Taylor Rule-determined interest rate that is below zero. This is demonstrated in the graph below: the federal funds rate is stuck near zero, while the Taylor Rule would imply that more stimulative policies (i.e. a negative effective interest rate) are desirable.
But many economists believe that a cure can be provided by moderate levels of inflation. Since it is only the nominal interest rate affected by the zero lower bound, effective (or inflation-adjusted) interest rates are still capable of falling below zero in accordance with the Taylor Rule's recommendations. A nominal central bank interest rate of 0.25%, as we currently have in the US, is the equivalent of a -0.75% rate with our inflation at about 1%. If inflation was 4%, however, the Federal Reserve would have a lot more flexibility to act in accordance with the Taylor Rule. The lowest possible nominal rate, which is essentially 0.25%, would be the equivalent of a particularly stimulatory effective rate of -3.75%.
The rate that the Taylor Rule calls for has fallen lower with each recession. As I mentioned above, I believe that this is due to a decline in the natural rate of interest, driven by a variety of factors. This has been referred to by some as secular stagnation. For now, the zero lower bound has declined in relevance. The US and Europe are recovering and before long the Fed and the ECB will be in position to raise interest rates. But don't expect the previously normal rates of the late 90's at around 5%. Instead, we'll probably creep back up to 1.5% before the next recession hits. At that point, the rate needed to respond effectively will be even lower. We can respond to that next crisis the way we responded to this one, by having our recovery held back by an insufficient response of monetary policy, or we can act to alleviate the suffering of millions and respond to needlessly high unemployment rates, by pursuing inflation targets closer to 4%. A higher inflation target will safeguard against recessions by enabling a stronger response from central banks.
Originally Answered: Is moderate inflation good for the economy?
Here's a way to understand how money supply goes up in a country and hence inflation happens:
If a country has 1000 rupees. And 1000 people, assume each person has 1 rupee in hand.
1000 people go and deposit the money in Bank A.
Bank A can give 90% of it as loans. 10% is cash reserve ratio.
90% of of Rs.1000 = Rs.900
Rs.900 is given as loans to different people. For simplicity, imagine Rs.900 is given to a business man who is going to start a factory. Bank A gives a cheque of Rs.900 to the business man. The business man deposits this cheque in Bank B.
Assume he has 100 employees. He is going to spend this Rs.900 to pay salaries to these employees and do business. (For simplicity, assume that there are no other expenses in the business other than salary).
All these 100 employees have salary account in Bank B only. So this Rs.900 is circulated within the different accounts on Bank B and does not leave the bank.
Now Bank B has Rs.900 in its asset. Bank B can give loans of 90% of the deposit!!!
That's Rs.810.
So the original money which was only Rs.1000 with 1000 people is now getting inflated because of banking system.
How much is it inflated? Approximately 10 times because the cash reserve ratio is 10%. 100/10 = 10.
If the cash reserve ratio is only 5% then 100/5 = 20. The money in the system (country) multiplies by 20.
See this chart...
![]()
The above chart is truncated. The 10% cash reserve is kept and 90% is given as loan continuously.
So the total cash in the system becomes Rs.10,000 from the original Rs.1000
When 1 onion costs Rs.1 in the country with 1000 people having Rs.1 each, it will cost Rs.10 / onion when 1000 people have Rs.10 each. Only the numbers have gone up. Onion production has not gone up. This is INFLATION.
The money supply is increased by 10x considering that all people use debit cards and netbanking instead of using cash.
You can understand that some people hold cash and do not deposit it in the bank. That cash never becomes loans and hence doesn't multiply.
All governments discourage using cash because cash doesn't grow.
Notice that Rs.10,000 exists only when Rs.9000 as loans exist in the system. As long as more and more people are taking loans, inflation happens because all this new money is built on the foundation of loans.
Imagine you are buying a car for Rs.5,00,000 and you take a loan from the bank. The car dealer deposits this money in the same or another bank right. And the bank gives loan again on the 90% of Rs.5,00,000 and it keeps going on.
Now you understand why the biggest buildings and highest paid people are bankers, right?
This may look like a huge ponzi scheme. But that's how it works.
Now imagine what happens when people start paying back these loans. If all the loans are paid back in the above chart then the money supply should go back to Rs.1000 right?
Yes, that's deflation and deflation is healthy for the economy.
But governments can't afford deflation for various reasons - the No.1 being they have huge debts. During inflation debtors gain and savers lose because cost of living goes up. During deflation, debtors lose and savers gain. (That's another big story).
Governments want "continuous growth" meaning continuous inflation. So the reduce the CRR (cash reserve ratio).
If CRR is made 5% then the original money supply can become 20x.
If you reduce interest rates, more loans, more inflation.
When you bring down the interest rates to 0%, you can't lower it. But there is a way to lower it - called QE (quantitative easing).
If a country has 1000 rupees. And 1000 people, assume each person has 1 rupee in hand.
1000 people go and deposit the money in Bank A.
Bank A can give 90% of it as loans. 10% is cash reserve ratio.
90% of of Rs.1000 = Rs.900
Rs.900 is given as loans to different people. For simplicity, imagine Rs.900 is given to a business man who is going to start a factory. Bank A gives a cheque of Rs.900 to the business man. The business man deposits this cheque in Bank B.
Assume he has 100 employees. He is going to spend this Rs.900 to pay salaries to these employees and do business. (For simplicity, assume that there are no other expenses in the business other than salary).
All these 100 employees have salary account in Bank B only. So this Rs.900 is circulated within the different accounts on Bank B and does not leave the bank.
Now Bank B has Rs.900 in its asset. Bank B can give loans of 90% of the deposit!!!
That's Rs.810.
So the original money which was only Rs.1000 with 1000 people is now getting inflated because of banking system.
How much is it inflated? Approximately 10 times because the cash reserve ratio is 10%. 100/10 = 10.
If the cash reserve ratio is only 5% then 100/5 = 20. The money in the system (country) multiplies by 20.
See this chart...
The above chart is truncated. The 10% cash reserve is kept and 90% is given as loan continuously.
So the total cash in the system becomes Rs.10,000 from the original Rs.1000
When 1 onion costs Rs.1 in the country with 1000 people having Rs.1 each, it will cost Rs.10 / onion when 1000 people have Rs.10 each. Only the numbers have gone up. Onion production has not gone up. This is INFLATION.
The money supply is increased by 10x considering that all people use debit cards and netbanking instead of using cash.
You can understand that some people hold cash and do not deposit it in the bank. That cash never becomes loans and hence doesn't multiply.
All governments discourage using cash because cash doesn't grow.
Notice that Rs.10,000 exists only when Rs.9000 as loans exist in the system. As long as more and more people are taking loans, inflation happens because all this new money is built on the foundation of loans.
Imagine you are buying a car for Rs.5,00,000 and you take a loan from the bank. The car dealer deposits this money in the same or another bank right. And the bank gives loan again on the 90% of Rs.5,00,000 and it keeps going on.
Now you understand why the biggest buildings and highest paid people are bankers, right?
This may look like a huge ponzi scheme. But that's how it works.
Now imagine what happens when people start paying back these loans. If all the loans are paid back in the above chart then the money supply should go back to Rs.1000 right?
Yes, that's deflation and deflation is healthy for the economy.
But governments can't afford deflation for various reasons - the No.1 being they have huge debts. During inflation debtors gain and savers lose because cost of living goes up. During deflation, debtors lose and savers gain. (That's another big story).
Governments want "continuous growth" meaning continuous inflation. So the reduce the CRR (cash reserve ratio).
If CRR is made 5% then the original money supply can become 20x.
If you reduce interest rates, more loans, more inflation.
When you bring down the interest rates to 0%, you can't lower it. But there is a way to lower it - called QE (quantitative easing).
Originally Answered: Is moderate inflation good for the economy?
Definitely. Inflation is just pressure that keeps money moving through the system. To have a vibrant economy, you want money to constantly be in action rather than stagnating. Of course, too much pressure is dangerous and the same goes for inflation.
This leads to a few advantages. The main one is that it incentivizes people who have stuff (ie assets) to go out and actually put them to use. This way more things get done, which is generally beneficial for society. This means more money circulating, more people getting paid, more businesses making revenue, more taxes... All good things.
Another advantage is in fighting against a particular sort of cognitive bias: nobody likes their wages decreased. And yet, rationally, there are times when wages should be decreased. Luckily, this bias can be fooled by keeping the nominal wages the same: as long as the number stays the same, you're happy. Even if, in real terms, the number is actually worth less year over year!
Having more assets circulating also makes things more liquid. If people are more actively buying and selling, it's probably easier to buy or sell whatever you need. This makes doing actual business easier. The main point of the economy is to move necessary things between people who need them, which is exactly what liquidity helps with.
As an interesting detour, consider real estate. Generally, there is a fixed supply of land. You can't just create more, especially in the middle of a city! This means that land is inherently deflationary. If you have a prime spot of land in the middle of a city (but not enough resources to build anything), it would be in your interest not to sell this year, since it will be worth more in the future! But since you're not using it, everyone would actually be better off if you sold it. After all, we don't want our city centers full of empty lots! I figure this is one of the reasons we have property taxes, which can counter the deflationary nature of land and make it easier to buy and sell it.
This extra kick to make people use or sell valuable land—which is beneficial for the city as a whole—plays exactly the same role as inflation in general. We want to run our economy at a reasonable utilization, putting most of our resources to work most of the time. Inflation is a nice decentralized way of making this happen.
At the same time, inflation is not without risks. In some sense, it's an implicit tax on assets. Since government bonds are denominated in currency, inflation is like an extra source of revenue. This could allow a government to levy an extra tax even if it would be opposed, rationally or not. This (rightly) worries some people. However, it does not mean we should not have any inflation! It's just something important to consider.
And, of course, inflation run amok can completely destroy an economy and leads to a true economic theater of the absurd:
![]()
Using bills for kindling thanks to hyperinflation
This too is a worry, but, again, not a case against inflation in general. After all, drinking too much water can be fatal, but that doesn't mean you should stop drinking water at all!
This leads to a few advantages. The main one is that it incentivizes people who have stuff (ie assets) to go out and actually put them to use. This way more things get done, which is generally beneficial for society. This means more money circulating, more people getting paid, more businesses making revenue, more taxes... All good things.
Another advantage is in fighting against a particular sort of cognitive bias: nobody likes their wages decreased. And yet, rationally, there are times when wages should be decreased. Luckily, this bias can be fooled by keeping the nominal wages the same: as long as the number stays the same, you're happy. Even if, in real terms, the number is actually worth less year over year!
Having more assets circulating also makes things more liquid. If people are more actively buying and selling, it's probably easier to buy or sell whatever you need. This makes doing actual business easier. The main point of the economy is to move necessary things between people who need them, which is exactly what liquidity helps with.
As an interesting detour, consider real estate. Generally, there is a fixed supply of land. You can't just create more, especially in the middle of a city! This means that land is inherently deflationary. If you have a prime spot of land in the middle of a city (but not enough resources to build anything), it would be in your interest not to sell this year, since it will be worth more in the future! But since you're not using it, everyone would actually be better off if you sold it. After all, we don't want our city centers full of empty lots! I figure this is one of the reasons we have property taxes, which can counter the deflationary nature of land and make it easier to buy and sell it.
This extra kick to make people use or sell valuable land—which is beneficial for the city as a whole—plays exactly the same role as inflation in general. We want to run our economy at a reasonable utilization, putting most of our resources to work most of the time. Inflation is a nice decentralized way of making this happen.
At the same time, inflation is not without risks. In some sense, it's an implicit tax on assets. Since government bonds are denominated in currency, inflation is like an extra source of revenue. This could allow a government to levy an extra tax even if it would be opposed, rationally or not. This (rightly) worries some people. However, it does not mean we should not have any inflation! It's just something important to consider.
And, of course, inflation run amok can completely destroy an economy and leads to a true economic theater of the absurd:
This too is a worry, but, again, not a case against inflation in general. After all, drinking too much water can be fatal, but that doesn't mean you should stop drinking water at all!