Why if I have $100 right now, 10 years later that same $100 will have less purchasing power? Why can’t our money retain its value over time, I’ve earned it but why does the value of my time and effort go down over time?
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Here’s the thing, the value of money is driven by supply and demand (as with virtually everything else). The Fed could target a supply of money that meets the demand, and over the long run it would have zero inflation. The problem is that monetary policy (i.e. the Fed’s tools) work with “long and variable lags”. This means that a single change in interest rates won’t fully impact the money supply for months, maybe even a year or more. It’s like trying to parallel park an 18 wheeler but not knowing how long the trailer is.
The way central banks compensate for this is to target an inflation rate slightly above 0% so that if they overshoot, inflation does not go negative. Negative inflation tends to create a downward spiral in the economy as people slow down their spending causing inflation to go even more negative. The judgement of policy makers is that a scenario of 2% inflation with low risk of deflation is better than 0% inflation with high risk of deflation.
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