Why a Little Inflation is Actually Good for the Economy


“Inflation is causing stress.”
“Bad news about prices in the grocery store.”
“…historically high inflation.”

In 2022, much of the world experienced a period of uncommonly high inflation. The U.S., U.K., and Eurozone all peaked at around 10%, meaning that prices were on average 10% higher than the previous year.

While it’s a relief that inflation is now closer to normal, it’s important to note that this doesn’t mean prices are down; they’ve just stopped climbing as fast.

This situation is still stressful for consumers, challenging for businesses, and a headache for governments.

But here’s a twist: If you consume a lot of inflation-related content, you’ll often hear that a little inflation is actually a good thing.

So, if rising prices seem to hurt everyone, why can’t inflation be zero?

The Virtuous Cycle of Inflation

First off, governments and central banks don’t want zero inflation. Most countries aim for an “inflation target” of about 2%.

This number is somewhat arbitrary, but it’s meant to encourage a “virtuous cycle.”

Here’s how it works: When prices are generally rising, people expect them to continue rising. This expectation encourages spending now rather than later, especially on big purchases like cars or appliances, to avoid higher costs in the future.

Essential goods like food and clothing also get pricier, forcing us to spend more.

As a result, companies make more money, which means they can employ more people. More people with jobs means more spending, driving demand and prices higher.

This cycle continues as long as wages keep pace with inflation.

When wages rise alongside prices, people can still afford the same goods, maintaining their standard of living.

When Inflation Goes Wrong

However, from 2021 to mid-2023, wage growth in the U.S. lagged behind inflation, squeezing many households.

Although this trend has reversed, with wages, especially at the lower end, now outpacing inflation, wages in the U.S. have been stagnant for a long time.

While rising wages are good, they’re not yet high enough.

Disruptions in this cycle, such as supply chain issues and price gouging by companies, can lead to high inflation like we saw recently.

This turns the virtuous cycle into a vicious one.

Tools to Combat Inflation

Governments combat rising inflation mainly by raising interest rates, which makes borrowing more expensive.

Higher borrowing costs discourage spending and investment, slowing down the economy. This approach was used by the U.S.

Federal Reserve in 2022, helping to bring inflation closer to the 2% target, but also increasing financial strain on families.

The Dangers of Deflation

Conversely, falling prices, or deflation, might sound good but can lead to a deflationary spiral. If prices drop, consumers might delay purchases, hoping for even lower prices.

Lower spending means companies make less money, leading to layoffs. Unemployed people spend even less, causing prices to fall further.

This cycle slows economic growth and is hard to fix because governments have fewer tools to combat deflation.

Why 2% Inflation?

Setting an inflation target just above zero helps prevent the economy from slipping into deflation.

Inflation will always fluctuate due to the complex interplay of millions of individual and business decisions.

Keeping inflation at a slightly higher rate creates a buffer against the risk of deflation.

So, while hearing that “a little inflation is a good thing” might be annoying, it’s a necessary part of maintaining economic stability.

It ensures that prices don’t fall into a dangerous deflationary cycle, keeping the economy healthy and growing.

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In summary, while inflation can be frustrating, a little bit is essential for a healthy economy.

It encourages spending and investment, supports job growth, and helps avoid the perils of deflation.

Understanding this delicate balance can help us better appreciate the economic policies that influence our daily lives.