When inflation is kept at a low level, it is beneficial. There are two different contexts in which this might take place. The first scenario is when people anticipate rising prices due to inflation. People tend to put off purchases until they have to avoid spending more money in the future. In the near run, demand will rise as a result of this. Because of this, businesses are making more money currently via increased sales and production. It is more probable that they will recruit more employees to match the demand. It initiates a positive feedback loop, which in turn stimulates economic expansion.
The second benefit is that it eliminates the potential for deflation. When this occurs, prices tend to go down. When this occurs, many put off their purchases hoping that prices would go down even more. It has a dampening effect on demand, which in turn causes firms to lower their inventory. Consequently, manufacturers are producing fewer goods and laying off people. The unemployment rate goes up, bringing about a wage inflation decrease.
Because workers have less money available to spend, demand is falling even more rapidly. Companies are implementing price cuts. This makes the deflation much more severe. Due to this factor, deflation is an even greater threat to the expansion of the economy than inflation is. During the Great Depression, there was a 10% drop in prices globally.
The Fed's Role in Maintaining a Stable Inflation Rate
The Federal Reserve has established the official goal for inflation at 2%. The Federal Open Market Committee (FOMC) said on the 27th of August, 2020, that it would be willing to accept a target inflation rate of more than 2% if it was determined that this would assist maximize employment. It continues to strive for an inflation rate of 2% over time but is ready to permit higher rates if inflation has been relatively low for an extended period of time.
That is the rate of inflation at the core level. It disregards the erratic costs of gasoline and food. It is not the rate from one month to the next but from one year to the next. Ben Bernanke served as chairman of the Federal Reserve from 2006 to 2014 and was the first person to establish a goal for the Fed's inflation rate.
Targeting the inflation rate may stimulate demand by altering people's expectations about the rate of inflation. They think that the Fed will ensure that prices will continue to rise. This motivates people to shop as soon as possible before costs increase.
The country's central bank adjusts the interest rate to maintain inflation at a level of around 2%. If inflation does not reach the goal level, the Federal Reserve will decrease interest rates to stimulate lending. If an increase in inflation exceeds the Fed's objective, then the Fed will raise the interest rate. Monetary policy now places a significant emphasis on inflation targeting as an important component.
When Inflation Pose Harmful Concerns
If inflation is more than 2%, the situation is risky. During a period of walking inflation, price increases range from 3% to 10% annually. It has the potential to drive an excessive amount of economic expansion. At that rate, inflation takes away the value of the funds you've worked so hard to achieve. The costs of the products you purchase every day are increasing at a rate that is higher than wage growth. Because of creeping inflation, it now costs $24 to purchase the same amount of goods one dollar could buy in 1913.
The 1980s were marked by a period of escalating inflation. As a result, former United States President Ronald Reagan is infamously quoted as saying, "Inflation is as aggressive as a mugger, as terrifying as an armed robber, and as lethal as a hitman." It needed interest rates in the double digits and a recession to halt the runaway inflation. Thankfully, we haven't had to deal with it again since then.
The Federal Reserve knows the four factors that contribute to inflation far better today than it did in the 1980s, which is one of the reasons why inflation has not returned. By boosting interest rates, the government can more rapidly put the brakes on growing prices.
Examples of Inflation
Both inflation and deflation may be seen in the housing market simultaneously. Up until 2006, investors were drawn in by progressively increasing prices. They saw that there was an opportunity to increase their wealth by purchasing items now and selling them at a later date. As a result, additional employment was generated as house builders attempted to keep up with demand.
The property market went through significant deflation between 2006 and 2010. There was a 30% drop in price. Those who could purchase a home chose against doing so until the market had stabilized. They discovered that the more they waited, the cheaper the prices were.
