If inflation is bad, and deflation is worse, then what is the best possible scenario for a country(that suffers from inflation)’s economy?
In: 8
The reason inflation and deflation are bad is that they tend to cause runaway effects, though due to slightly different patterns.
With inflation, the runaway effect occurs when inflation is noticeable between when money is earned and when it can be spent or invested, which is typically 2-4 weeks. This occurs as people will start to factor that inflation into pricing by increasing prices, thus causing inflation. This effect only really starts at around 13% annualized inflation (1% per month), and really kicks into gear around 24% annualized inflation (2% per month). Such high levels of inflation is likely to start to affect the government’s ability to pay its charges, encouraging it to print even more money, thus causing more inflation. At low levels, such as the normal target of 2% annualized inflation, inflation does not cause these problems, though it can still have problems if some prices are not adjusted for inflation – which is common with those set by law, such as minimum wage, welfare, and tax brackets.
Deflation gets its runaway effect as people will slow down purchases if they know they can buy the same item for cheaper later. Stuffing money under a mattress, thus removing it from the economy, also becomes a viable, and fairly low risk, investment strategy. Both of these will start to shrink the economy, thus causing more deflation. As the economy shrinks, people producing luxury goods are laid off, causing even less money to be circulating and causing more deflation. The process will eventually stop when the economy has shrunk to necessities and basic luxuries – people cannot stop buying food, and very few people would be willing to live without some luxuries, if they can afford them.
With all of that in mind, the normal target is about 2% inflation. This is enough to avoid dipping into deflation, which can runaway very quickly, while not being high enough to have inflation start to cause problems.
Latest Answers