The Federal Reserve typically targets an annual rate of inflation for the U.S., believing that a slowly increasing price level keeps businesses profitable and prevents consumers from waiting for lower prices before making purchases. There are some, in fact, who believe that the primary function of inflation is to prevent deflation.
Others, however, argue that inflation is less important and even a net drag on the economy. Rising prices make it harder to save money, driving individuals to engage in riskier investment strategies to increase or even maintain their wealth. Some claim that inflation benefits some businesses or individuals at the expense of others.
KEY TAKEAWAYS
- Inflation describes a situation where prices tend to rise.
- Economists believe inflation is the result of an increase in the amount of money relative to the supply of available goods.
- While high inflation is generally considered harmful, some economists believe that a small amount of inflation can help drive economic growth.
- The opposite of inflation is deflation, a situation where prices tend to decline.
- The Federal Reserve targets a 2% inflation rate, based on the Consumer Price Index (CPI).
How Can Inflation Be Good For The Economy?
Understanding Inflation
Inflation is often used to describe the impact of rising oil or food prices on the economy. For example, if the price of oil goes from $75 a barrel to $100 a barrel, input prices for businesses will increase and transportation costs for everyone will also increase. This may cause many other prices to rise in response.
However, most economists consider the actual definition of inflation to be slightly different. Inflation is a function of the supply and demand for money, meaning that producing relatively more dollars causes each dollar to become less valuable, forcing the general price level to rise.
The Federal Reserve targets a 2% annual inflation rate, believing slow and steady price increases help encourage business activity.1
Benefits of Inflation
When the economy is not running at capacity, meaning there is unused labor or resources, inflation theoretically helps increase production. More dollars translates to more spending, which equates to more aggregated demand. More demand, in turn, triggers more production to meet that demand.
British economist John Maynard Keynes believed that some inflation was necessary to prevent the Paradox of Thrift. This paradox states that if consumer prices are allowed to fall consistently because the country is becoming too productive, consumers learn to hold off their purchases to wait for a better deal. The net effect of this paradox is to reduce aggregate demand, leading to less production, layoffs, and a faltering economy.2
Inflation also makes it easier on debtors, who repay their loans with money that is less valuable than the money they borrowed. This encourages borrowing and lending, which again increases spending on all levels.
Economists once believed an inverse relationship existed between inflation and unemployment, and that rising unemployment could be fought with increased inflation. This relationship was defined in the famous Phillips curve. The Phillips curve was somewhat discredited in the 1970s when the U.S. experienced stagflation.
How Does the Government Measure Inflation?
In the United States, the Bureau of Labor Statistics (BLS) publishes a monthly report on the Consumer Price Index (CPI). This is the standard measure for inflation, based on the average prices of a basket of consumer goods.
What Causes Inflation?
Milton Friedman famously described inflation as the result of «too much money chasing too few goods,» resulting in higher prices. Inflation can sometimes be the result of an increase in the money supply due to government spending. It can also be the result of increased demand or a shortage of consumer goods. Following the COVID-19 pandemic, inflation rose sharply in the United States, largely due to supply chain bottlenecks and emergency government spending, including stimulus checks sent to households.