Danger: Inflation Is Toxic!
Why are high levels of inflation bad for the economy?
It is common knowledge nowadays that (high) inflation is bad for the economy. This is the main reason why Central Banks, during and after the 1980s, started to set targets for the inflation level. But why is it so? Why is inflation so important to us?
First, we should understand what economists usually refer to as “inflation”. The definition that a first-year undergrad student will give would be similar to this one: “inflation is a general rise in the price level in an economy over a period of time”. Now, what does this mean?
Let’s make it easier: take a coffee in Milan, it is usually around 1€. The same coffee in five-year time will cost 2€. So, the cost of the same coffee after a period of time has doubled. This is inflation: a general (namely, not only our coffee in Milan but also a croissant in Rome) increase in the price level over a period of time (it can be one month, one year, ten years, etc.).
Once we understood what its meaning is, it may be relevant to look at how inflation is measured in practice. There are many different ways to do it and the most common one is with the so-called CPI, Consumer Price Index. The idea behind it is quite intuitive: we look at how the prices of goods that are regularly consumed (e.g. beef, cheese, etc.) change over time. In practice, if in 2020 a coffee was 1€ and in 2021 it increased to 1.10€, we say that there has been a 10% increase in inflation over one year.
Having understood these simple facts, we can now tackle our initial problem: why are high levels of inflation harmful for the economy?
There is no single answer to this question and we will explore the main ones.
1. Reduction in the Purchasing Power of Money
Money, as time passes, loses its ability to buy goods and services. For my usual coffee in Milan in 2021 I need 1€ plus 0.10€, while just the year before I needed only 1€. To make a more compelling example, think of a person who wants to buy a car at a price of 20k. Suppose that, for some reason, instead of buying it this year, she will wait one year and suppose that inflation is very high (e.g. 50%). The same car will cost to that person no more 20k, but 30k after one year. So, my 20k today cannot buy anymore the car I wanted and I will need an extra 10k to buy it — i.e. money lost some of its purchasing power.
2. Uncertainty and Safe Haven Assets
High levels of inflation foster uncertainty among people and investors, thus having a significant negative effect on investment decisions. In turn, these facts lead to movements of capital to safe haven assets. An interesting example is the role played by gold as safe asset both during the Great Financial Crisis and the current Coronavirus crisis.
3. Income Redistribution and Fiscal Drag
During periods of high inflation, we experience a redistribution of income from creditors to debtors. To get an intuition, think of a debt contracted by a person to buy a house: suppose that she makes a 10k loan from a bank and will need to repay in 5 years the 10k plus a 10% interest rate — 11k in total. However, as the contract is in nominal terms, if there is an (unexpected) increase in inflation, the real value of the loan to be payed back will be lower. This is because inflation, as we have seen, erodes the real value of money, so the bank will have a lower purchasing power — i.e. the 11k that will receive after the 5 years will have a lower real value than expected. Moreover, if inflation is high enough, it can be that, after the 5 years, the bank will get a sum of money that — in real terms — has a lower purchasing power than the 10k it lent to the borrower (thus having a loss). So, in general, with inflation (high and unstable) there is usually a redistribution of income from creditors (in our example the bank) to debtors.
The same problem applies to taxation: tax brackets are in nominal terms. Therefore, people will pay higher taxes due to increases in nominal wages but without having a real increase in purchasing power as inflation increases too, thus harming the economy and low-income people in particular.
Inflation Targeting
We have now seen some of the consequences of high levels of inflation and how severe they can be for the economy. Why then many Central Banks have a positive inflation target? The European Central Bank, for example, has an inflation target in its mandate which is “close but below 2 percent”. Why is 2 percent and not zero? If, as we have seen, inflation damages the economy, why do they set a positive inflation target and do not set it equal to zero?
The idea behind this decision is that, first of all, a positive (but low!) level of inflation helps the adjustments of relative prices in the economy — meaning that the economy works smoothly and with less frictions. Secondly, if the target is set equal to zero, it may well be that the economy falls in a situation of deflation (i.e. negative levels of inflation) and deflation is probably even worse than inflation, as it has additional problems to the ones already mentioned, and it is even more difficult to fight with the standard monetary policy tools. As a matter of fact, Central Banks are more capable of “fighting” (and also more prepared to accept the consequences of) moderate-high inflation levels than reacting to deflation. As argued before, the costs of deflation are even greater than those of inflation and, moreover, Central Banks have to deploy additional measures to counteract it — what have been termed non-standard monetary policy tools (such as Quantitative Easing, TLTRO, etc.).
For this reason, there is an ongoing debate among scholars on whether there should be an upward revision of inflation targets, precisely to have a greater margin of maneuvering in case of recessions — meaning, a greater distance between the target and the deflationary rate.
