Inflation is always a controversial topic in the field of economics. Even the use of the term "inflation" carries different meanings depending on the context. A significant number of economists, businessmen, and politicians believe that a moderate level of inflation is necessary to drive consumer spending. They argue that increased spending plays a crucial role in promoting economic growth.

The Federal Reserve (FED) often aims to control inflation at a moderate level in the long term. Their view is that slow price increases help businesses maintain profits and prevent consumer expectations of price decreases before making purchasing decisions. Some even argue that the primary function of inflation is to prevent deflation - an economic nightmare.

However, on the flip side, many believe that inflation does not bring many benefits and can even hinder economic development. Soaring prices make saving more difficult and push people into risky investment choices to increase or at least preserve their assets. This perspective also emphasizes that inflation may benefit some businesses or individuals but harm others. So does inflation really have any effect? And why shouldn't it be zero?

Understanding Inflation

The term "inflation" is often used in daily life to describe the price increase of essential items such as oil or food. For example, when the price of oil jumps from $75 to $100 per barrel, input costs for businesses and transportation costs also rise. This creates a chain reaction pushing up prices of many other items to offset costs. However, economic experts have a deeper view of inflation. They define inflation as the result of the interaction between money supply and demand.

In other words, when the amount of money in circulation increases, the value of each unit of currency decreases, forcing overall prices to rise to balance it out. Inflation affects the economy in many ways, but the most noticeable consequence is reduced purchasing power. Even though the nominal value of money remains the same, during inflationary periods, the same amount of money will buy fewer goods and services. This means that even if workers receive wage increases to cover living expenses, they still feel a noticeable decline in their purchasing power for everyday consumer goods, rent, and other expenses. To control inflation, the Federal Reserve often implements tight monetary policies, typically raising interest rates. This dynamic action creates a domino effect on the financial market, pushing up borrowing costs, including credit card interest rates.

High interest rates make borrowing more expensive, negatively impacting business investment and consumer spending. Consumers limit their spending, leading to reduced production and slower economic growth. In this scenario, business profits decline, the risk of layoffs increases, putting significant pressure on households. This chain of negative effects can lead to an undesirable outcome, economic downturn. The challenge for the Federal Reserve is to find a balance between controlling inflation and maintaining an acceptable unemployment rate. However, these two goals often contradict each other.

Tightening monetary policy can help curb inflation but also poses the risk of increasing unemployment rates and pushing the economy into a prolonged recession. Economists believe in the existence of an inverse relationship between inflation and unemployment, illustrated by the Phillips curve. According to this theory, rising unemployment rates can be addressed by accepting higher inflation. However, this theory was heavily questioned in the 1970s when the United States experienced stagflation, a rare economic phenomenon where high inflation coexisted with high unemployment and stagnant economic growth.

Who Benefits and Who Suffers from Inflation?

The impact of inflation on individuals and groups varies. Those who benefit the most are borrowers, homeowners with mortgage loans, individuals with stable jobs, and currency holders. Inflation reduces the value of money over time, meaning the amount borrowers have to repay in the future is worth less in real terms than when they borrowed it. For example, if you borrow $10,000 during a high inflation period, that debt will decrease in value over time, making it easier for you to repay.

Inflation can also drive up property prices. This helps homeowners increase their asset value and reduce debt burdens. However, this is true only for loans with fixed interest rates; if interest rates float, they may rise with inflation, diminishing the benefits for borrowers. During inflationary periods, businesses often cut costs by laying off employees or reducing wages. However, those with stable jobs and bargaining power are less affected by inflation. Additionally, the domestic currency often depreciates against stronger foreign currencies, giving an advantage to currency holders as they can exchange for domestic currency at a more favorable rate. Those who suffer from inflation are consumers, homebuyers, and retirees relying on fixed incomes.

Inflation drives up prices of goods and services, reducing the purchasing power of consumers, especially those with fixed or slower-growing incomes who struggle to afford living expenses. Inflation pushes property prices higher, making it difficult for many, especially young people and low-income earners, to afford homes. Those relying on pensions or fixed-income investments also bear the brunt of inflation because the real value of the money they receive decreases over time. Although social security and other government benefits are adjusted for inflation, welfare increases often lag behind price hikes, leaving retirees at risk of reduced purchasing power and difficulty maintaining their standard of living.

Why Shouldn't Inflation Be Zero?

In 2022, much of the world experienced unusually high inflation rates. The US, UK, and the Eurozone all peaked at around 10%, meaning average prices were over 10% higher than a year earlier. Although this figure may surprise many, the good news is that inflation is now approaching normal levels, albeit still slightly high. However, the concern is that the inflation chart only reflects the rate of change, not a decrease in prices; they simply stop rising rapidly, causing difficulties for consumers and stress due to soaring prices. Businesses struggle to maintain operations, and governments must find ways to control the situation. Amid current inflation concerns, a common question is whether "a little inflation is good."

In fact, many economists believe that a certain level of inflation is necessary for a healthy economy. So why is the cost of living increase considered beneficial for everyone? Why can't inflation be zero? There are several reasons why inflation cannot and should not be zero. Firstly, many governments and central banks do not want this in many countries. Actively pursuing what is known as the inflation target usually around 2% as in the US today. This figure is considered the sweet spot for wage and price spirals in the economy.

So how does this wage-price spiral work during times of rising prices when people tend to anticipate further price hikes? This encourages immediate spending on big-ticket durable items like cars or appliances to avoid paying more later. Essential items like food and clothing also become more expensive, forcing consumers to spend more.

As a result, companies earn more profits, create more jobs, and increase income for workers, continuing to drive demand and push prices higher, creating a self-reinforcing cycle. The key point of this wage-price spiral is that as long as wages keep pace with inflation, people can still afford a similar amount of goods. However, this does not always happen. For example, in the US, wage growth lagged behind inflation for 2 years. It wasn't until mid-2023 that this trend began to reverse. Clearly, wage growth is a positive sign, but it doesn't mean current wages are high enough. Any disruption in this cycle, such as supply chain disruptions leading to unreasonable price hikes by businesses, can lead to high inflation, as we have seen in recent years. As mentioned, to control inflation, governments can use tools like raising interest rates.

This makes borrowing more expensive, curbing spending and investment, ultimately slowing down the economy. This is the approach the Federal Reserve took in 2022 to help bring inflation closer to the 2% target. However, raising interest rates also puts financial pressure on households, especially those who need to borrow to cover living expenses. Therefore, a careful balance must be struck between controlling inflation and maintaining economic growth. In contrast to inflation is deflation, where prices decrease. While deflation may sound positive at first, it can also create a negative spiral when prices fall. Consumers delay purchases hoping for further price drops in the future.

This causes businesses to lose revenue, forcing them to cut costs by laying off employees and further lowering prices to attract buyers, resulting in an economic downward spiral, reduced demand, and stagnant growth. Deflation is very difficult to overcome because governments do not have many effective tools to deal with it as they do with historical inflation. Solving deflation often requires strong interventions in the economy, such as massive government spending, as seen during the Great Depression, where economic downturns were only resolved through a surge in World War II spending. Because of the inherent risks of deflation, the 2% inflation target becomes crucial, creating a safety buffer that allows central banks to have.

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