I have been reading a BBC news article about inflation in the UK, which is saying that inflation has recently become negative (http://www.bbc.co.uk/news/business-33147660). The article suggests that this is a bad thing. However, I would have thought that positive inflation is generally a bad thing, because it creates instability, resulting in people spending all their money rather than saving it. Certainly, I know that hyperinflation can cause a huge deal of trouble. Can somebody explain why positive inflation (in modest quantities) is necessarily a good thing?
I am copying and pasting from an answer I wrote at From an economics perspective, what are the ramifications of a currency with fixed money supply?
A moderate degree of currency inflation serves a number of useful functions in the economy. The most obvious are:
- It induces people to spend their money before it loses its value. In a deflationary environment there is an incentive to put money under your mattress and spend it in a year when it has greater purchasing power. If everbody does this then the lack of demand will lead to a decrease in overall economic activity (i.e. a recession).
- It provides a weapon against downward nominal rigidities. For example, workers are generally reluctant to accept a nominal pay cut, even if market conditions are such that the current wage is above the equilibrium level. Inflation means that their employer can simply increase wages at less than the inflation rate so that the real wage is decreasing.
- It erodes the real value of nominally denominated debt. Now, this is obviously only a pseudo-advantage because (whilst it benefits debtors) it harms creditors. However, this kind of erosion of debt may be desirable if national economic stability is threatened by high debt levels. Also, since debtors are usually poorer on average than creditors, it can reduce inequality, which may be a normative objective for the government.
Without inflation you miss out on these benefits. The first benefit might not seem like a big deal if you think you can simply set the rate of inflation at zero percent. But it is very hard to hold inflation constant at some target level so attempting to hit zero inflation will almost certainly result in occasional lapses into deflation, with the attendant negative economic consequences.
currency is like a taxi for your wealth, and inflation is indirectly the fare that you are charged while using this method of transportation for your wealth. If deflation becomes a reality, you are being paid to take a taxi instead of paying for it, so you are gonna stay in the taxi when you really should be getting on with your life. On the other hand, when there's too high an inflation, its as if the fare was too expensive, and then you'll prefer walking.