ELi5: Why is inflation so important for the economy to go?



I meant Grow*

In: Economics

It encourages you to spend/invest as if you hold cash it will decrease in buying power. If zero inflation then decreased incentive to buy/invest.

Inflation is the decrease in “value” of any single piece of currency. This is represented by increasing prices; since a “dollar” is worth less next year than last year, a loaf of bread (worth some relatively fixed value) will cost more dollars next year than last year.

Inflation is caused by increased money supply; more physical (or digital) money moving around in the economy. This is what makes the money worth less; since there are more dollars, each dollar is worth less.

This is helpful to make the economy grow because it encourages people to spend their money. If you have 100 dollars now and can buy 100 loaves of bread today, but the same money next year can only buy 90 loaves of bread, then you are “losing” money each year (actually, you’re losing “value”, but it’s six of one or half-dozen of the other).

To reduce this “loss”, you should spend your money now instead of next year. This can either be to buy things (eg. a book won’t lose value like money will) or to invest in things (investing in a business may make more money for you than you would lose, so you’d net-gain money). Making money/value move around is what the economy is. Investing money into new businesses, technologies, and/or education improves our capability to make things, which grows the economy, as it increases the “value” that we have access to.

Economies depend on money being useful, whether for buying things, passing hand to hand or by being invested so that businesses and people who need to borrow have access to capital. Without inflation, people might choose to delay spending (no worries, prices will be same next year!) and sit on money (no need to invest, my $1000 will still buy same next year when sitting under my mattress). Also, a couple percent of inflation is important to prevent deflation (falling prices) which make the no inflation situation even worse — more delayed spending or investing when prices are actually falling.

Ultimately, money is just counters is a world wide game. Like poker chips at the casino.

Because of the constant efforts of human labour and exploitation of natural resources to produce finished goods, the total value of the entire system goes up over time. So as the economy grows, you have to create more counters to keep track of it.

But to encourage the growth of the economy through human labour and investments, you need to add slightly more counters than the current economy size.

Another reason to deliberately create inflation is deficit spending. If you are spending money you don’t really have, you still need to create new counters for those transactions.

Inflation encourages spending, because the longer you hold on to your money, the less you can buy with it. Spending grows the economy by putting more money into circulation. You buying that tv allows the store to pay their workers and suppliers, the workers take that money and spend it on things they need, the suppliers pay their workers, etc.

Deflation encourages saving, because the longer you hold onto your money, the more you can buy with it later. However, if no one is spending money, then money isn’t circulating through the economy, meaning businesses aren’t making money and can’t pay their workers, who then can’t pay for the things they need, etc.

I would call inflation more of a side effect of growth rather than a precondition. No one that wants to encourage growth would recommend that everyone simply raise their prices.

What ends up happening is that the tools used to fight inflation — tightening credit, raising interest rates, etc — end up slowing the economy down. Central banks will do this! But they will only do so much of it. They will slow down an overheated economy to prevent high inflation, but they won’t grind the economy to a complete halt just to get zero inflation. The sweet spot is usually low but non-zero inflation.

in a perfect world, we might not have inflation. we might hold all things to zero.

but… its not a perfect world, and no matter how precise you attempt to control a thing, it will wiggle around.

Deflation is disasterous. the idea that money is increasing in value, tells people to horde cash, if I wait till tomorrow to spend, I get more than I can get today.

but now demand falls, so prices fall, I can get even more, so I keep waiting. and waiting. and waiting. and it feeds on itself, until we are all unemployed because no one buys anything, so no one is working.

So we try to keep a small rate of inflation, so we dont risk ever having deflation.

A couple of reasons;

1. As has already been mentioned it’s a tax on holding onto your money that incentivizes people to either buy things or invest their cash rather than sticking it under a mattress.

2. Getting out of a recession frequently means people taking a pay cut. People are pretty understanding about not getting a raise during bad economic times but will flip out if their employer actually tries to cut their pay. Inflation acts as a “phantom” pay cut during bad times and this tends to moderate the boom and bust cycle of the economy.

3. Deflation is much worse for the economy than inflation, and we can’t really control inflation perfectly so building a little bit of inflation in as a safety cushion makes sense. We’re a lot better off with an average of 3 percent inflation that fluctuates between 0 and 6 percent than we would be with an average of 0 percent that fluctuates between 3 percent deflation and 3 percent inflation.

Inflation also leads some people to start a new business as their product or service can finally be profitable especially since inflation doesn’t lift all prices evenly. Some costs might go down with respect to the revenue gained from selling a product or service.

Inflation is a means of devaluing wages without telling the workers (or negotiating with them) they are taking a pay cut.

There’s two answers to this.

One is “why is it good”? Others have explained that: it provides an incentive to keep the economy in motion. Without it, all expenditure and all investment becomes a game of chicken, because it’s always rational to wait. Not only to buy things, but to invest in developing penicillin or computers. Even if you have an idea, the longer you wait, the cheaper it will be to develop.

The other is “when is it good?” Some of the nuttier opponents of fiat currency, be their Bitcoin bros or Q Anon gold/silver hoarders, thing that there should be a fixed amount of money in an economy. But that’s inherently deflationary (at least, with occasional blips like the black death, since the dark ages). The invention of, say, the spinning jenny allows the same number of people to make more stuff in the same time; the invention of production lines means that you can make a lot more cars than if you are bespoking them in a shed. That’s growth: the economy is bigger. The poorest man alive can shave with a razor which would make the king of France jealous, to roughly paraphrase an economist whose name I cannot remember. That’s because what was in 1750 exotic and expensive — a sharp, usable razor — is now cents.

It makes no sense to say “OK, the amount of money is fixed where it was in 1750” because there’s just more stuff, more available. So if you fixed the money supply, you would either have savage deflation or again no particular reason for anyone to develop anything, as you could only charge a fraction of what its predecessor cost.

So inflation is good, as it drives development and increase in the standard of living, and inevitable, as things develop and standards of living increase.

For the economy to grow, you need new companies to be able to start up/expand. They typically do this by borrowing money and paying interest. Without inflation, lenders are much less motivated to lend out any of their money, since they could just sit on it and stay just as rich. Without this lending, companies can’t start up or grow as easily, and the economy cannot grow as fast

From my econs class, inflation occurs when aggregate demand (total demand) increases, total demand = more people spending/buying = economy growing. On the graph as AD increases it shows the price will go up = inflation. But this is from a economic theory perspective. Other factors are important when it come to determining whether the inflation is actually beneficial to the economy. The best is a low steady inflation rate.