I have read in several places that inflation should be positive, at about 2%-3%. The most recent example was in this answer from another stack exchange site.
How is this value obtained and under what assumptions?
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3 Answers
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Another reason why inflation needs to be positive is so that interest rates can be cut in a recession in order to stimulate spending. When interest rates get too low, an economy encounters a liquidity trap and further expansionary monetary policy cannot be implemented.
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We're creatures of asymmetry. We're loss-averse. And we're not particularly rational, a lot of the time.
So, to be able to do things like real-terms wage reductions, it's much easier to implement a freeze in nominal wages within an environment of positive inflation, than nominal reductions within an environment of zero inflation. So some inflation allows for relative and absolute adjustments in remuneration of different jobs.
But too much inflation creates too much uncertainty and instability.
So, 2-3% is currently considered to be "goldilocks" inflation within developed economies: neither too much, nor too little, but just right. Other places, and other times, have had different ideas.
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In addition to the reasons provided by EnergyNumbers, there are possibly a few more, such as:
Deflation (even if small) is broadly considered worse that moderate inflation. This is because deflation is very difficult to fight. If consumers expect prices to fall (because of deflation) they will wait before consuming and push consumption into the future. This fall in current demand reduces prices again, which increases deflation. The cycle then keeps going on, which is a phenomenon known as the deflationary spiral. One reason deflation is bad is for the same reasons inflation is bad (e.g. menu costs). On top of that, deflation is an issue because it increases real wages, which increases costs of firms, which can have negative effects on employment. Japan has tried to fight deflation unsuccessfully for some time for example, leading to what is called "Japan's lost decade". So once you get a little deflation it may persist for a long time. Policymakers are potentially scared, that if they are always at 0 inflation that a small shock could push them into deflation, which is very bad. So having small, positive inflation is a buffer against deflation.
Many countries have estimated or continue to estimate inflation using a Laspeyres index. It is well known, that such an index has an upward bias, i.e. overestimates inflation. Let's say we want to have 0 inflation. If the Laspeyres index says we have 0 inflation, we probably have negative inflation, which is also not optimal. So measurement error provides a case for positive inflation numbers.
Inflation provides government revenue through what is called "inflation tax". Further, most governments are in debt and holders of debt profit from inflation.
