Inflation: not too little, not too much
Inflation is the rate at which prices in the economy change over time. Inflation could be positive which means that prices are increasing. If it is negative, then prices are decreasing. In that case we say that the economy is experiencing deflation, i.e. falling prices.
Two more terms. We say that an economy is experiencing disinflation if its inflation rate is declining. For example, in the 1980’s the inflation rate in the U.S. declined from double digit to single digit levels. Hyperinflation is an extremely high level of inflation. There is no official threshold beyond which inflation is considered to be hyperinflation but price increases of 40-50 percent per month clearly can be categorized as hyperinflationary.
In principle, countries try to maintain inflation of about 2-3 percent per year. This is too low to cause problems for businesses and consumers, yet relatively far away from negative inflation, i.e. deflation. Deflation is a problem because it could cause a downward spiral. Households delay they purchases because they expect prices to fall. Because of that, firms cannot sell their products and are forced to lower prices. Then, household expect even lower prices and so on. Prices keep falling and products and services are not sold.
In 2010, for example, only a few of the countries on the chart managed to keep inflation below 3 percent. Many countries had higher inflation and Japan experienced deflation.
Two more terms. We say that an economy is experiencing disinflation if its inflation rate is declining. For example, in the 1980’s the inflation rate in the U.S. declined from double digit to single digit levels. Hyperinflation is an extremely high level of inflation. There is no official threshold beyond which inflation is considered to be hyperinflation but price increases of 40-50 percent per month clearly can be categorized as hyperinflationary.
In principle, countries try to maintain inflation of about 2-3 percent per year. This is too low to cause problems for businesses and consumers, yet relatively far away from negative inflation, i.e. deflation. Deflation is a problem because it could cause a downward spiral. Households delay they purchases because they expect prices to fall. Because of that, firms cannot sell their products and are forced to lower prices. Then, household expect even lower prices and so on. Prices keep falling and products and services are not sold.
In 2010, for example, only a few of the countries on the chart managed to keep inflation below 3 percent. Many countries had higher inflation and Japan experienced deflation.
Economic costs associated with high inflation
It is difficult to predict future prices: When prices increase rapidly, it is difficult to predict what things will cost in the future. Then, workers are not sure what wages to request, firms are not sure what prices to set, banks are not sure what interest rates to put on loans, etc. The uncertainty makes everyone cautious. The banks lend less money and the companies don't invest as much. Naturally, the economy slows down.
Wealth transfers from savers to borrowers: If a lender gives a $100 loan at 5% interest, they will get back $105 in one year. However, what if inflation turns out to be 50 percent during that year? The $105 dollars would not be worth much by the end of the year. By giving the loan at such low interest rate, the lender has essentially given free money to the borrower.
Menu costs: Menu costs are the costs firms incur for the update of their documents, price lists, etc. The higher the inflation rate, the more frequent these changes have to be. Imagine a restaurant that has to reprint all of its menus every 3-4 months. This can add up to quite a bit of money.
Shoe leather costs: Shoe leather costs refer to the cost of frequent trips to the bank. When inflation is high, people don't keep much money in cash as it rapidly loses value. Instead they leave it on deposit to earn interest. At the same time, they need ever larger amounts of cash to make transactions. As result, they have to go to the bank more frequently, "wearing out the leather of their shoes."
It is difficult to predict future prices: When prices increase rapidly, it is difficult to predict what things will cost in the future. Then, workers are not sure what wages to request, firms are not sure what prices to set, banks are not sure what interest rates to put on loans, etc. The uncertainty makes everyone cautious. The banks lend less money and the companies don't invest as much. Naturally, the economy slows down.
Wealth transfers from savers to borrowers: If a lender gives a $100 loan at 5% interest, they will get back $105 in one year. However, what if inflation turns out to be 50 percent during that year? The $105 dollars would not be worth much by the end of the year. By giving the loan at such low interest rate, the lender has essentially given free money to the borrower.
Menu costs: Menu costs are the costs firms incur for the update of their documents, price lists, etc. The higher the inflation rate, the more frequent these changes have to be. Imagine a restaurant that has to reprint all of its menus every 3-4 months. This can add up to quite a bit of money.
Shoe leather costs: Shoe leather costs refer to the cost of frequent trips to the bank. When inflation is high, people don't keep much money in cash as it rapidly loses value. Instead they leave it on deposit to earn interest. At the same time, they need ever larger amounts of cash to make transactions. As result, they have to go to the bank more frequently, "wearing out the leather of their shoes."
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