According to the Economist Newspaper Limited (Para 1), inflation has been long considered to affect the economy adversely as it constrained investment and increased the impact of taxation on the consumers. It is surprising how it is now viewed as a solution to the rich world’s economic troubles. If central bank was to increase the level of money supply that would reduce real interest rates in an economy experiencing recession, it would be easier to restore cost-competitiveness. This would also help in reducing private and public debt burdens on the rich world’s economies. Inflation can thus be said to contain both advantages and disadvantages.
Very low inflation levels as well as high inflation levels do more harm than good. Increase in inflation would enable the monetary policy to respond more aggressively to economic shocks that would tend to increase the level of wages. Wages should be tied to productivity, but workers are reluctant to receive pay cuts when levels of output decrease. A cut in real wages is easier to disguise with an inflation rate of 3-4 % than a rate of 1-2 % (The Economist Newspaper Limited Para. 3).
The Economist Newspaper Limited looks at the effect of inflation to the government debts in rich economies. Revenues are increased but it pushes taxpayers into higher income brackets where they face heftier tax rates, the anxiety about indebtedness makes inflation seem all the more appealing but the rich economies will blunder by increasing spending as long as households will look down to pay the debts. Inflation will fuel the process since it will reduce the real value of mortgages.
The author focuses on the effect of inflation on investment, taxation, government expenditure, wages and consequently consumption, and government debt. He concludes that the best policy would be talking tough about inflation while keeping interest rates low for as long as possible. These are policies in macro-economic policy since they are all consistent with the macro economic goals of price stability, full employment, and economic development. We will look at these issues in order to determine the consistency of the author of the article with the macroeconomic theory.
Effects of inflation on Investment
Macroeconomics is the branch of economics concerned with aggregates, such as national income, consumption and investment. Inflation is one of the factors that affect these aggregates. Inflation causes many distortions in the economy. When prices increases, consumers living on fixed income cannot buy as much as they could have bought previously. Their purchasing power decreases, and this discourages savings which are required to finance investments that boost economic growth. Businesses are also tasked with a hard responsibility of planning for the future. They cannot precisely predict how much to produce, since it is difficult to determine the amount of demand of their goods at the higher prices they will be forced to charge for their goods. Inflation causes uncertainty about future prices, interest rates, and exchange rates, and this in turn increases the risks among potential trade partners. The uncertainty associated with inflation increases the risk associated with the investment and production activity of firms and markets. When inflation makes nominal values uncertain, investment planning becomes difficult, as a result, investment is inhibited which affects economic growth (Gerolamo, p. 3).
Debate on Wages
How much inflation is too much? This has been a debate by most economists, by some advocating for 0 % inflation for advanced economies while general consensus is reached that a little inflation is good. The biggest reason behind this argument is the case of wages. In a theoretical world, a 2 % wage increase during a year with 4 % inflation has the same effect to the worker, as a 2% wage decrease in a period of zero inflation. In the real world situation, workers tend to refuse wage cuts at any time. Many economists thus will support the opinion that a small amount of inflation, about 1-2 % a year is more beneficial than detrimental to the economy. The main idea is that in order to keep the same real wage in time of inflation, the after tax wage should increase with the increase in the rate of inflation (Barnes, Para 8).
The inflation Tax
All government spending represents a tax. Printing money in order to pay for federal spending dilutes the value of the dollar, which causes higher prices of goods and services. This mostly affects the middle and the low-income earners. The federal deficits are financed by borrowing or taxation. Borrowing is only marginally better than taxation. It may delay the pain but the cost must eventually be paid. The tax is paid when prices rise as the result of depreciating dollar. Inflation will also push taxpayers into higher income brackets where they will face heftier tax rates. Ron (Para 5) confirms that inflation tax affects the lower and middle classes more than the rich, as they hold a larger fraction of their income in cash. This is due to the fact that inflation tax results from expansionary monetary policy subtracting value from cash and cash equivalents that is held.
When the expenditures of a government are greater than its tax revenues, it creates a deficit in the government budget which can be financed by borrowing the public which amounts to the government debts. Printing money would have an adverse effect on people who lent the government money. They would see a fall in the value of their bonds. In case there is a hyper inflation, the value of the bonds would be worthless and they would be unwilling to lend the government money in future. This scenario was evident in Germany in the 1920s, where the government started to print money as a result of broken economy. Money became worthless such that people had to be paid twice per day as money decreased in value by the hour.
Effect of inflation on Consumption
Inflation can distort investment and consumption decisions. The recent U.S. experience with low, stable levels of inflation, in the range of 2 to 3 Percent, has spurred policy makers to consider the possibility of achieving zero per cent inflation. This will however come with costs of lost output and unemployment during the adjustment. Inflation will damage consumption levels due to households’ and businesses’ uncertainty about inflation’s future course. Inflation affects personal income taxes and thus it distorts decisions on how much to spend on housing. This interaction plays out with owner-occupied housing, where mortgage interest payments are deductible. Inflation is thus built into nominal interest rates, such that a moderate rise in the price level increases this deduction (Hellerstein, Para 15).
Opinion and Conclusion
Inflation has adverse effects on both the rich economies and the third world economies. It affects the levels of savings, consumption, government expenditure and other macroeconomic tools. Low levels of inflation are healthy for rich economies as it acts as a stimulus to the general output level. Inflation will increase the level of money supply in the economy which consequently reduces the interest rates. A reduction in interest rates encourages firms and businesses to borrow funds since most of their discounted projects obtain a positive net present value, as a result of decrease in interest rates. This will act to increase output and this will expand the economy.
Low inflation means that the continuous rise in the general price level drops to such a low level that it no longer influences the decisions of consumers and producers. This is consistent with the author’s position which he feels that an inflation rate of 2-3 % would do the economy well rather than a zero inflation rate. It is argued that zero inflation would allow consumers make long-term plans for retirement or future investment with less worry. They overlook the fact that getting to zero inflation can be costly and which will involve loss of output and higher unemployment during the transition. The benefits of obtaining a zero inflation rate are not worth the cost to be borne in form of lost output and increase in unemployment.
It is sometimes stated that higher inflation will create jobs, this is not true. Higher inflation destroys jobs in the long run although lowering inflation might have a short-term negative effect on job creation. The paper has clearly shown the negative effects of high inflation which would have more adverse consequences to the economy, than the effects of attaining a zero inflation rate. The economy benefits from a little bit of inflation. A critical assumption underlying this result is that firms can continuously adjust their production to satisfy demand.
The government is thus tasked with a vital role of ensuring that inflation rate does not increase which will be contrary to the promise of price stability. It is also to maintain a level of inflation which will motivate the economy so as to increase output. In my view, the government would concentrate efforts in achieving lower inflation rates than maintaining a 2-3 % inflation rate. This is due to the fact that the effect of higher inflation rate, which can be occasioned by the government relaxing its non inflationary measures, are dire compared to effect of attaining a zero inflation rate.
Barnes Ryan. The Importance of Inflation and GDP, 22 April 2010, 27 April 2010 from http://www.investopedia.com/articles/06/gdpinflation.asp
Gerolamo Donald, Inflation and Its Effects on Investment, 10 March 2010, 27 April 2010 from http://econc10.bu.edu/Ec341_money/Papers/Gerolamo_paper.htm
Hellerstein Rebecca, The Impact of Inflation, winter 1997, 27 April 2010, from http://www.bos.frb.org/economic/nerr/rr1997/winter/hell97_1.htm
Ron Paul, the Inflation Tax, 17 July 2006, 27 April 2010, from http://www.house.gov/paul/tst/tst2006/tst071706.htm
The Economist Newspaper Limited, The inflation solution, 12 February 2010, 27 April 2010, from http://www.economist.com/business-finance/economics-focus/displaystory.cfm?story_id=15663312