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Why do governments require moderate inflation and which are its effects on the economy?


Most people have heard about inflation in the news; it is an omnipresent phenomenon with global significance. It can be defined as a measure of the rate of rising prices of goods and services in an economy. In other words, it implies a decrease in the purchasing power of people. To elucidate the main topic of this article, it is important to first explain certain functions and basic economic principles that contribute to its understanding.

Recalling the formula M*V = P*Y, where M = money supply, V = velocity of money, P = price level, and Y = real GDP, certain things need to be noted. At the core of it, we know that V and Y do not change as easily. Thus, a change in P, the price level, can occur through a change in the money supply in the long run. In the short run, however, this acts as a temporary solution to actually increase spending and output. In detail, when the economy is running below capacity, it has unused labor and resources that, if used, could raise production. A solution could be to inject more money into the economy by utilizing monetary policy. More dollars result in more spending, and this raises GDP. According to Keynesian theory, the proper response to an economic recession is more risk-taking, fewer savings, and more spending. The multiplier effect also plays a big role in this. It basically implies that a certain amount of government spending usually leads to an even bigger change in the final income. In economics, the fiscal multiplier is the ratio of change in national income arising from a change in government spending.

Main point

It is important to tie in the principles mentioned above with the justification as to why governments want inflation, a word that often has a negative connotation. The first reason is that it helps debtors pay back the loans with money that has less value, something that encourages borrowing. Most importantly, it additionally aids the US Government to pay back its enormous debt. This is true especially right now when it has risen dramatically during the efforts to recover from the economic effects of COVID-19, so it really cushions this huge burden.

Rising prices make it easier for companies to put up wages, giving them the flexibility to give raises, but not as much as inflation. In a world of zero inflation, some companies might be forced to cut wages. In some countries, it can even be used before elections to raise output and economic activity temporarily. This demonstrates the variety of reasons why governments set a target ( 2% for example), and try to avoid being above, but also below it. The methods of doing so may be, for instance, by utilizing contractionary or expansionary monetary policy. Finally, steady prices signal a healthy economy, which, in turn, could attract foreign investors and exhibit a prosperous economic environment.

Final thoughts

In conclusion, these statements do provide brief reasoning regarding the initial question. In the complex world of today, however, there are many other justifications as to why this happens.

An important quote to remember by the Austrian philosopher and economist Ludwig von Mises: “ Inflation is not an act of God, inflation is not a catastrophe of the elements or a disease that comes like the plague, inflation is a policy”.



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