Essay on why inflation can be good for the economy?
The price of a gallon of milk might not seem like much to you just $2.50 on average nationwide but consider this: If it were priced at $9.99 per gallon, it would cost consumers an extra $7 billion each year due to inflation, according to the Bureau of Labor Statistics’ Consumer Price Index (CPI) report. And that doesn’t include other things we pay for regularly, such as gasoline, food, rent, and utilities.
If you’re a parent, think about how inflation could affect your child’s college savings plan. A $10,000 investment today will grow to $11,118 by 2039 with 5 percent annual inflation, based on data from Bankrate.com. By contrast, investing $10,000 now grows only to $8,816 in 2039 with no inflation. That’s a difference of $1,212 over two decades.
That may seem pretty insignificant when compared to the overall economy, but inflation is one reason why economists have warned people against putting all their eggs into one basket. When inflation gets out of control, it hurts savers and encourages spending.
But what does inflation mean exactly? Simply put, inflation occurs when the general level of prices goes up across the board. The rate at which these prices are rising determines whether inflation is mild, moderate, or severe. Severe inflation rates range between 3 and 4 percent annually while moderate range between 2 and 3 percent, according to the Federal Reserve System. Mild inflation rates fall between 1 and 2 percent.
While inflation isn’t necessarily “bad,” there are some exceptions. For example, when inflation is low, companies aren’t able to raise prices as high because they don’t want to lose customers. But when inflation increases, companies usually do increase prices so they can make higher profits and attract new clients.
How Does Inflation Affect Economic Growth?
According to many economists, inflation has had a negative effect on economic growth ever since President John F. Kennedy signed the Economic Report of 1963, which set federal interest rates too aggressively during his administration. These interest rates held down consumer demand and made it harder for businesses to expand.
Since then, inflation has been blamed for causing recessions in 1973-1975, 1980-1981, 1990-1991, 2001-2002, 2004-2005, and 2007-2009. During those periods, unemployment rates went above 7 percent for several months, which was twice the national average at the time.
So why did inflation cause recession after recession? Economists say it comes down to supply and demand. The problem wasn’t that businesses weren’t making enough profit, but rather that consumers didn’t spend their money in other ways, such as saving it or investing it instead. When consumers save less and invest more, banks stop lending them money because there isn’t enough cash around to lend. This causes a chain reaction throughout the economy, resulting in lower production and fewer jobs.
To avoid another recession, the U.S. government needs to keep inflation under control, especially when the country is experiencing strong economic growth. To prevent inflation, the government must create more jobs, improve the quality of existing jobs and encourage citizens to spend their money.
One way to do this is through monetary policy, also known as controlling the money supply. The goal of monetary policy is to maintain stable prices and maximize employment levels. There are three main tools used to accomplish this: open market operations, reserve requirements, and special drawing rights. Open market operations involve buying and selling treasury securities.
As part of its open market operations, the Fed buys bonds back from investors and sells them to the public to reduce the number of available funds. Reserve requirements require banks to hold certain amounts of cash reserves, which helps slow down the creation of more money. Finally, special drawing rights allow central banks to purchase commercial paper issued by member countries without having to convert it into cash first.
Monetary policies can help combat inflation, but they can also hurt economic growth. For example, to fight inflation, the Fed raised interest rates sharply in 2003 and 2004, which slowed down business expansion. On top of that, the Fed increased the size of its balance sheet meaning the total amount of bank deposits it owned from $900 billion in 2002 to $3 trillion in 2008.
Because banks were required to keep larger balances, they started hoarding the money instead of using it to loan more people money. With less liquidity, banks couldn’t give loans to small and medium-sized businesses, which were essential for creating jobs. This led to slower job growth during 2005-2006.
What Causes Inflation?
There are many factors that influence inflation, including taxes, energy costs, international trade, and even the weather. Let’s take a closer look at what influences inflation most.
Taxes are often considered a major factor in inflation, but it depends on who pays the tax. If the burden falls on workers, then employees end up paying more for necessities like gas, groceries, and housing. However, if employers bear the burden, then companies pass along the cost to customers.
According to a study published by the Organization for Economic Cooperation and Development (OECD), the United States ranks 15th among 34 OECD nations for corporate income tax rates. Meanwhile, Japan ranks first with a rate of 24.5 percent, followed closely by Singapore with 23.6 percent.
Energy costs also play a big role in keeping prices high. Since oil accounts for roughly 40 percent of U.S. imports, rising fuel prices lead to higher inflation as well.
Trade barriers can also increase inflation. In 1979, Congress passed legislation designed to protect American industries from foreign competition. One result of this law was tariffs, which added about 8 percent to the price of imported goods. Tariffs are charged when buyers import products from outside the United States. They are meant to discourage exports, but they actually cause inflation by raising prices for everyone.
Finally, the weather can impact prices. Rainfall affects transportation systems more than any other factor, accounting for nearly half of the increase in transport costs.
With all these variables, figuring out the exact causes of inflation can be tough, but here are some common culprits:
Food Prices: Rising food prices caused both the 1970s oil crisis and the Great Depression. After World War II, farmers received huge subsidies to produce more crops, and this continued until 1977. Due to high crop yields, the government gave farmers aid money to buy seeds and fertilizers, which increased the prices of agricultural goods.
International Trade: International trade makes up about 30 percent of U.S. GDP and has become increasingly important in recent years. Imports account for nearly 60 percent of U.S. consumption expenditures and provide cheap commodities that drive up labor productivity. But this also leads to inflation because manufacturers pass along the costs to consumers.
Interest Rates: Interest rates directly affect loan availability and prices. During the Great Recession, the Federal Reserve lowered interest rates in response to falling stock markets. The stock market eventually recovered, but the damage done to home values and personal wealth remains.
Some economists believe that the best way to fight inflation is to eliminate the fed budget deficit entirely. Eliminating the deficit would decrease the number of dollars circulating in the economy, allowing the Fed to adjust interest rates more easily. Others argue that reducing deficits won’t solve inflation problems alone. Instead, they’d need to focus on increasing domestic output.
Goods vs. Services: How does inflation compare to wage growth?
After the 1970s, economists debated whether the goal of the free enterprise system should be price stability or economic growth. Many believed that price stability would promote greater long-term economic growth. Some argued that inflation was necessary to stimulate growth and help companies compete globally.
However, others said that inflation can stymie growth and ultimately hurt the economy in the long run [sources: Wrenn, Ruhm]. For example, the late Harvard economist Gregory Mankiw says that although short-run fluctuations in inflation and real GDP are correlated, the relationship becomes weaker over longer periods. He argues that because inflation eats away at future purchasing power, it holds back economic growth.
Economist Milton Friedman agreed, arguing that inflationary pressures hurt economic growth because they force workers to cut back on discretionary purchases. He believed that the solution to inflation was for governments to control wages and salaries.
Other economists disagree and say that fighting inflation requires stimulating the economy to boost demand for goods and services. In other words, inflation helps stimulate the economy, whereas slowing down the economy hinders inflation.
Today, many economists recognize that inflation and economic growth don’t always go hand in hand. In the next section, we’ll discuss how inflation and economic growth work together.
The debate rages on regarding the effects of inflation on economic growth. While some economists believe that inflation stimulates economic growth, others claim that inflation impedes economic growth.
Studies show that inflation has different results for various parts of the economy. Inflation stimulates economic growth in industries where supply and demand remain constant, such as retail sales.