I’ve read that many banks want a certain level of inflation and I don’t really see why. Why is important to banks that a stable product costs more tomorrow than today?
Is it to make people spend their money more since storing it will eventually make is worth less?
In: Economics
According to the classical theories, long-term GDP/GNI growth in an advanced economy should be about 3% per annum with inflation of around 1.5-2% – hence why the target range for the Federal Reserve or Bank of England is exactly that range – 1.5-2% inflation
There is much empirical evidence of how destructive DEFLATION is to an economy. Imagine economic activity is doing well in real terms with year-on-year growth in goods and services produced and sold, but the overall growth of the economy (value of those goods and services) is negative. That’s what can happen with deflation, which is a real killer. Japan has been trying to fix deflation for 40 years and counting, it still hasn’t got there, despite pioneering Modern Monetary Theory (printing to infinity)
The OP is correct in that inflation encourages spending and borrowing. If your money is going to be worth less in future, you may as well maximize your value via buying now, which increases economic activity and the velocity of money. Crucially, when BORROWING, inflation erodes the real-terms burden of repayments. If you borrowed $1 million today at 0% interest, you will effectively pay back significantly LESS than $1 million in real-terms dollar-adjusted via compounded inflationary effects. If there is deflation, you pay back significantly MORE in real terms. So you can see why those who are doing the most borrowing – our governments and banks – are on a path where inflation is not only desirable but pretty much essential. This is mirrored by consumer spending patterns and we all hope to use inflation to erode our debts.
In the most simplistic terms, inflation is good because deflation is bad. It would be possible to have 0% inflation but this is not congruent with an economy that is adding new people and increasing economic participation/ improving productivity amongst existing participants. Inflation is a desirable by-product of organic growth in a debt-driven financial system. Of course inflation must not be allowed to get out of control because hyperinflation is even worse than deflation, e.g. Venezuela, Zimbabwe
Latest Answers