Inflation-Too Little, Too Much

Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. We have all felt inflation, for example, in first class postal rates.




Deflation is a decrease in the general price level of goods and services. Deflation occurs when the annual inflation rate falls below zero percent, resulting in an increase in the real value of money.

You may think deflation is a good thing: It definitely isn't. The Federal Reserve has been concerned about deflation this year. If an economy goes into a deflationary spiral, a depression can arise. This is what happened in the 1930s.

Until the 1930s, it was commonly believed by economists that deflation would cure itself.

When this idea failed during the Great Depression, government tried to boost demand through increases in government spending.

With modern monetarist economics, we fight deflation by expanding consumer demand through a lowering of interest rates.

It should be clear to readers that the Fed had done this in recent months--and now the Federal funds rate is near 0%. Other actions have been taken by the Fed--and now the US economy is awash in money.

So, the concern now shifts to inflation!

Too much inflation is bad for the economy.

• Uncertainty about future inflation may discourage investment and saving.
  

• High inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future.

Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. Thus, Fed Chairman Bernanke needs to take steps to reduce the monetary supply.

If he doesn't, many problems arise:

• Savers who are paid a fixed rate of interest will lose purchasing power from their interest earnings, while their borrowers benefit.
  

• Those with cash assets will experience a decline in the purchasing power of their holdings.

• Payments to workers and pensioners often lag behind inflation, especially for those with fixed payments.

• There will be inefficiencies in the market, and make it difficult for companies to budget or plan long-term.
  

• Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services in order to focus on profit and losses from currency inflation.

• Uncertainty about the future purchasing power of money discourages investment and saving.

• Inflation can impose hidden tax increases, as inflated earnings push taxpayers into higher income tax rates.

Let's take a look at an entertaining, and politically adoring, video from 1933 which provide another viewpoint on how interactions in the economy can have an impact on inflation.