Inflation: It's A Good Thing

By Douglas Rice | May 22, 2009 AAA

The Department of Labor said the Consumer Price Index (CPI) rose from -0.1% in March to 0%, or basically flat, in April. While increasing prices may not be what strapped consumer want to hear, it is exactly what economists want to hear, at least right now. (Learn more about how this information can help you out in The Consumer Price Index: A Friend To Investors.)
Prices are constantly changing. Most of the time up, sometimes down. Economists believe that an economy in which prices on average are increasing at a low rate of a bit less than 3% annually provides the best environment for economic growth.

High inflation lowers the value of our money so we can get fewer goods and services for each dollar. For example, when gas prices spiked, we all paid more for gas, but didn't get any additional benefit in return. It just cost us more to drive the same amount of miles. So we are worse off.

But the bigger concern with high inflation is the systematic increase that comes from what economists call an inflationary spiral. This happens when prices rise, so firms have more profits, so they hire more workers, this sends wages up, so people have more money to spend on higher priced goods, so demand increases, and the prices keep going up. (If you are dizzy, don't be alarmed. That's what happens to everyone when they are first exposed to economics.)

Just think of it as an upward spiral where prices keep rising, but we never really get anything more for our money.



How bad can this be? Good question. Currently, the official rate of inflation in Zimbabwe is 231 million percent. Yes, you heard that right. What cost 1 Zimbabwe dollar (ZWD) last year, costs 231 million ZWD this year. Basically, their money isn't worth the paper it's printed on. In fact, they just cut 12 zeros off the currency.

While the dangers of high inflation seem obvious, the opposite of inflation, deflation, is also dangerous. Some might say even more dangerous. Be forewarned, a deflationary spiral will also make you dizzy, but in the opposite direction. People get laid off, spend less, prices get cheaper, which leads to people waiting to make purchases as they think that prices will continue to fall, so firms cut costs and lay off workers to reduce prices further, but consumers have less money to spend so they still don't buy, so more people get laid off, and so on.

While falling prices (deflation) may seem like a good thing to the average consumer, it can devastate an economy by turning into a deflationary spiral. (Read more in Deflationary Shocks: Helping Or Hurting The Economy.)


This is why when prices stopped falling in April, the markets saw it as good news. The current goal is to increase inflation and grow demand so prices can rise, people will stop getting laid off.

So when is (a little) inflation a good thing?

Always.

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