What is the right amount of inflation?

[harikaried]

Ignoring existing reality with things like banks taking inflation into account for long-term 30-year mortgages, what is the ideal inflation rate?

It seems like the answer should be 0%, but why?

And what exactly does it mean to have 0%?

 

[rp08orbust]

What definition of "inflation" are you using?

If by inflation you mean the expansion of the fiat money supply by the central bank (which is the Austrian definition), then the correct amount is zero, because there shouldn't be a central bank.

If by inflation you mean overall increases in prices of goods and services (which is the monetarist's definition of inflation), then the correct answer is, "whatever price fluctuations a free market with sound money produces", which could very well mean decreases instead of increases in overall price levels, or increases for some things and decreases for others, etc.

Edit: The phrase "free markets with sound money" is redundant, because free markets always pick gold or silver as money and punish fraud (e.g., fractional reserve lending).

 

[stuntman stoll]

The "ideal" [price] inflation rate is whatever the market decides it should be. No one can perfectly predict the market, but we can hypothesize that in a free economy there would be strong economic growth and the market would probably choose gold as generally accepted currency. Gold supply generally inflates by a couple % per year, so you could probably expect [price] DEflation of around 1-4%

 

[Icymudpuppy]

The "ideal" [price] inflation rate is whatever the market decides it should be. No one can perfectly predict the market, but we can hypothesize that in a free economy there would be strong economic growth and the market would probably choose gold as generally accepted currency. Gold supply generally inflates by a couple % per year, so you could probably expect [price] DEflation of around 1-4%

Gold supply doesn't increase as fast as population. In a per-capita worldwide gold economy, gold supply would decrease and indeed prices would Deflate by tiny amounts.

 

[truelies]

The ideal would be a general price level which neither rises nor falls. Thus neither lenders nor savers are defrauded.

 

[rp08orbust]

The ideal would be a general price level which neither rises nor falls. Thus neither lenders nor savers are defrauded.

Price changes =/= fraud. If I buy a computer today and tomorrow it costs 10% less, I have not been defrauded.

Fraud is violating contracts.

 

[dannno]

Deflation seems ideal, as it seems a bit wasteful to have a bunch of miners going out constantly spending resources mining new material to make money with.. but they have every right to do it as long as they are respecting property rights and it is profitable for them.

 

[cubical]

Deflation seems ideal, as it seems a bit wasteful to have a bunch of miners going out constantly spending resources mining new material to make money with.. but they have every right to do it as long as they are respecting property rights and it is profitable for them.

exactly. there are wasted resources, but it is the least worst monetary system.

 

[Diurdi]

Deflation would most likely be the case. This would not be because the money supply is contracting, but because the average price level would be falling thanks to increased productivity and efficiency thanks to improving technology.

The money supply would probably increase depending on what commodity the money was based on. If it was a well managed fiat currency then the money supply would stay the same (give or take).

 

[Zippyjuan]

Question on the producer end. If you are a manufacturer- when do you decide you want to lower your prices and thus contribute to price deflation? If your costs are the same, lowering your prices reduces your margins. Yes, you could be pressured by competition perhaps. Say your costs were being lowered. Would you pass that along in the form of lower prices, in the form of higher wages for your workers or would you keep the profits for yourself and your shareholders? Historically, overall price deflations have happened when demand falls dramatically.

Or from another view- if you are a producer with not declining costs but have to lower your prices due to competion wouldn't you try to lower your wages to keep your profit margin- lowering part of your costs? If there is an extended period of price deflation the other thing that tends to occur is falling wages and higher unemployment. If you don't lose your job or get your wage or hours cut, a deflation is a good thing because it makes things cheaper for you. Otherwise you can end up worse off.

Deflation can be as destructive to an economy as inflation can be.

 

[Wesley123]

Milton Friedman always said it should be fixed at 5% or so annually, assuming we have a fiat currency of course.

 

[Nate-ForLiberty]

Question on the producer end. If you are a manufacturer- when do you decide you want to lower your prices and thus contribute to price deflation? If your costs are the same, lowering your prices reduces your margins. Yes, you could be pressured by competition perhaps. Say your costs were being lowered. Would you pass that along in the form of lower prices, in the form of higher wages for your workers or would you keep the profits for yourself and your shareholders? Historically, overall price deflations have happened when demand falls dramatically.

Or from another view- if you are a producer with not declining costs but have to lower your prices due to competion wouldn't you try to lower your wages to keep your profit margin- lowering part of your costs? If there is an extended period of price deflation the other thing that tends to occur is falling wages and higher unemployment. If you don't lose your job or get your wage or hours cut, a deflation is a good thing because it makes things cheaper for you. Otherwise you can end up worse off.

Deflation can be as destructive to an economy as inflation can be.

You still have to compete in the labor market. If your competition is lowering their prices, but keeping their wages the same, you have to do the same to stay competitive on both fronts. If you pay your employees less, they are likely to produce a substandard quality product or leave to go work for your competition where they can make more money.

If there is extended price deflation, that means either the product is becoming very cheap to produce and you don't need as many employees, or demand is dropping and you don't need as many employees. The market is saying, we don't need as much of this as we used to. It is better for people to find a job in another industry that is in demand as opposed to staying in a dying one. Resource reallocation.

 

[Zippyjuan]

How low would you be willing to go to keep a job or find a new one? 50%? People don't like to do that. Even if you tell them it will make what they buy less expensive. How is the "resource reallocation" going today? Not well and very slowly. Their jobs weren't needed so now they have to find new ones- except everybody has been reducing jobs so there are few new ones to move to- even at lower wages. We haven't really seen price deflations lately but the economy and job market are what one would expect.

 

[Nate-ForLiberty]

How low would you be willing to go to keep a job or find a new one? 50%? People don't like to do that. Even if you tell them it will make what they buy less expensive. How is the "resource reallocation" going today? Not well and very slowly. Their jobs weren't needed so now they have to find new ones- except everybody has been reducing jobs so there are few new ones to move to- even at lower wages.

Price deflation is a normal function of the market. What we have today is economic depression caused by high taxes, over regulation, and fiat currency.

Two completely different things.

 

[The Gold Standard]

How low would you be willing to go to keep a job or find a new one? 50%? People don't like to do that. Even if you tell them it will make what they buy less expensive. How is the "resource reallocation" going today? Not well and very slowly. Their jobs weren't needed so now they have to find new ones- except everybody has been reducing jobs so there are few new ones to move to- even at lower wages. We haven't really seen price deflations lately but the economy and job market are what one would expect.

Lower wages are acceptable with lower prices. What happens today is people have to take lower wages but prices continue to rise because our paper money loses value every day. You can't compare us today where we do not have a free market economy or a sound currency to how a true free market economy works on sound money.

 

[stuntman stoll]

Question on the producer end. If you are a manufacturer- when do you decide you want to lower your prices and thus contribute to price deflation? If your costs are the same, lowering your prices reduces your margins. Yes, you could be pressured by competition perhaps. Say your costs were being lowered. Would you pass that along in the form of lower prices, in the form of higher wages for your workers or would you keep the profits for yourself and your shareholders?

Those pressures always exist. Nothing unique when considering deflation. Business always wants to make more revenue and pay labor less. Consumers always want to pay less and labor always wants to make more. It is the opposing forces (not always equal) that lead to market equilibrium.

Historically, overall price deflations have happened when demand falls dramatically.

Look at the 1870s and 80s. There was stable money, a growing economy, and slow, constant deflation. This was America's industrial revolution when we basically went from being a 3rd world country to a world super power.

Deflation can be as destructive to an economy as inflation can be.

No. Deflation is never as destructive as inflation is. For starters, most bouts of deflation were the consequence of illigitamate paper currency inflation (yes, even during the gold standard). Secondly, when there is a bout of deflation, if the government does not get involved, the deflation is swift and complete without really interupting production (see 1920). When the goverment intervenes to slow/stop deflation, consumers and investors are unsure if prices ever hit bottom, so they stay on the sidlines (see great depression, current economy). On the other hand, inflation is what ruins economies and countless lives. It is the main cause of malinvestment and the wasting of resources

 

[harikaried]

What definition of "inflation" are you using?

Thanks. I think that's where I was getting caught up when explaining things to a friend.

If by inflation you mean the expansion of the fiat money supply by the central bank (which is the Austrian definition), then the correct amount is zero, because there shouldn't be a central bank.

Alternatively, one could pose the question as when is it right to either 1) inflate the money and steal value from those who already hold the money or 2) deflate the money by destroying money that people already hold.

If by inflation you mean overall increases in prices of goods and services (which is the monetarist's definition of inflation), then the correct answer is, "whatever price fluctuations a free market with sound money produces"

Right, although in the context of monetary supply inflation of the dollar, prices of goods are then more likely to be increasing to account for increased production costs -- the rate of reducing costs by increasing efficiency of production is likely to be less than that of money supply inflation.

 

[osan]

Ignoring existing reality with things like banks taking inflation into account for long-term 30-year mortgages, what is the ideal inflation rate?

It seems like the answer should be 0%, but why?

And what exactly does it mean to have 0%?

Where economics is concerned, there is more nonsense vomited forth from all quarters than any sane person should think possible.

That said, the true measure of economic health as far as your question is concerned is "purchasing power". Globally speaking (i.e. the overall purchasing power of any given individual, all else equal) individual purchasing power should remain steady perpetually, barring some extraordinary circumstance. If $1 buys a pound of some "average commodity" on day one, in a healthy economy it will purchase the same amount at some arbitrarily chosen date in the future. This is, of course, a very simplistic model, but it serves to illustrate the basic principle regarding the fundamental nature of sound money systems. There are several complicating factors that may alter this at the microscopic level and, perhaps one a longer time scale, the macroscopic.

Example: advances in widget manufacturing technologies drastically reduces costs, thereby causing widget prices to drop (possibly very significantly) over a relatively short time frame (could be long, too). In such a case, there is a shift in purchasing power per unit of currency for a given commodity, constituting a microscopic economic shift in overall purchasing power.

If, however, a disruptive technology becomes available that significantly reduces the manufacturing costs of nearly all products and commodities, then we would likely witness an increase in overall purchasing power constituting a macroscopic change in the economy. The effects of such systemic changes are not entirely predictable in the current system, but in a sound monetary environment, such technological advances should result in a net INCREASE in the average wealth of all people because their purchasing power has gone up, not down.

Therefore, sound money systems stand only to increase wealth rather than to ever decrease them. But even with sound money there is not guarantee that some circumstance might arise whereby average wealth decreases because purchasing power is diminished. Natural disasters and war come to mind as the most obvious and extreme examples of macroscopic effects. At the microscopic level, some shortage in a natural resource may result in a loss of purchasing power of that given commodity. For example, if drought or some pestilence strikes global corn crops and corn becomes scarce, the price will go up and the effective purchasing power of a unit of money will be diminished relative to corn. But these sorts of losses are usually transitory, but not always.

An example of this would be the case of wootz, a type of steel that became to be known as "damascus steel" or "watered steel". Wootz was legendary in that it made some of the best swords in the world and it was believed for a very long time that its qualities were imparted by virtue of the secret process for smelting the iron. As it turned out, the reason for wootz's superior qualities was the naturally occurring vanadium, which imparts toughness. When the ore vein ran out, the smelters closed shop because the other veins did not have the unknown additive and the steel they produced thereafter did not have the same qualities. Because of this, the purchasing power of any money gradually reduced with the availability of wootz. Once exhausted, no amount of money could purchase it because there was no longer any to be had. This microscopic loss of purchasing power was "permanent". It happens, but is relatively very uncommon.

As we can see, things are not so simple where the relationship between money and economies are concerned. Nevertheless there is a basic principle of monetary action that in part governs the way economies function and imparts to them a strong measure of stability in general, all else equal. This is a strong reason for having a properly sound system of money; it enhances prosperity all around, whereas unsound and easily manipulated systems of currency can be used to strip away general prosperity while shielding some favored group. But perhaps I digress.

Anyhow, all else equal, average purchasing power should remain constant over time. There should be no inflation stemming from a devaluation of the currency. With technological advances, average purchasing power should actually go up per unit money. Were this is not the case in general, I would tend to be fearful that some sort of broad issue of sustainability had arisen, which of course would be cause for great concern. That or war.

Does any of this make sense to you?

 

[Knighted]

If you pay your employees less, they are likely to produce a substandard quality product or leave to go work for your competition where they can make more money.

An interesting topic. This brought to mind another possible side effect of monetary policy that dictates a "constant" inflation rate significantly above 0%. When we consider that the threat of lower wages would cause an employee to seek out work with a competitor, also consider the effect of higher wages - or more precisely, artificially higher wages caused by inflation. If there is a constant, significant rate of inflation due to monetary policies, wages will likely rise at the same rate as prices. In other words, a person's buying power won't have significantly changed.

But consider the effect on the worker bee when he receives a 5% raise every year (the result of an inflation rate of 5%.) I'd wager that the worker would be far more satisfied with that 5% raise than seeing a 0% raise, even if prices of the goods he purchases dropped significantly and his buying power actually increased. Inflation leads to a worker feeling content with his employer's pay even though he's actually gaining nothing and is perhaps even losing ground. Is it possible that this distorts the bargaining power of workers? If workers believe they are being handsomely rewarded in raises due to wage/price inflation, the demand they make on their employers for higher wages (and the incentive to seek out higher paying positions) will be lower.

Conversely, if we had deflation, there would be -enormously- greater pressure on companies to give wage raises, because the average worker bee would look at his yearly pay and see it either stagnating or declining. This would take place even if the worker's buying power increased (decline in wages was less than the decline in prices.) I'm going to go out on a limb here and propose that the inflation caused by monetary policy could be responsible for some or all of the deceleration/stagnation in real wages that has occurred over the last 30 years.

 

[Zippyjuan]

Those pressures always exist. Nothing unique when considering deflation. Business always wants to make more revenue and pay labor less. Consumers always want to pay less and labor always wants to make more. It is the opposing forces (not always equal) that lead to market equilibrium.




Look at the 1870s and 80s. There was stable money, a growing economy, and slow, constant deflation. This was America's industrial revolution when we basically went from being a 3rd world country to a world super power.

Really? A bit of history of the time.

But the Gilded Age was showing signs of tarnish. In 1872, equine influenza had ravaged ranches and farms in the West. The “Great Epizootic” affected foodstuffs, dry goods, metal, lumber, manufacturing—every industry that employed horse-driven transit. Then came the Coinage Act of 1873. Formerly, the U.S. backed its currency with silver as well as gold. Now it went on the gold standard. Silver prices immediately fell off, and western mining slackened, throwing thousands of miners out of work.

In September 1873, a bank with enormous influence on Wall Street went belly-up. Jay Cooke & Company had invested too heavily in the ill-conceived and badly financed Northern Pacific Railway.

Other financial houses, similarly invested in railroads and other overpriced companies, soon began to falter, including Fisk and Hatch, which billed itself as “one of the richest and soundest in New York.” The New York Stock Exchange closed for the first time in its history and remained shut for ten days. In January 1874, hordes of angry unemployed men rioted in Tompkins Square Park, in one of the largest demonstrations in New York City’s history. In the end, 89 of the nation’s 364 railroads went bankrupt. Some 18,000 businesses had failed by 1875. Cotton mills and ironworks closed. Unemployment was rampant. Laborers, many of them Civil War veterans, wandered the countryside. Two words became commonplace: “tramp” and “bum.”

But in 1877, good weather spread across the nation. Crops were bountiful as the decade ended, and exports increased. Looking back in 1911, the New York Times reported: “Stocks began their rise in the spring of 1878, and in 1879, men of means awoke suddenly to the fact that the railroads were of value as investments after all, and a marvelous buying of securities sprang up, which electrified the financial world and led to a boom in prices.”

By now, it was clear: every boom had its bust, and good times were never forever. Then again, neither were bad times. The stock exchange thrived once more, and lenders became as common as borrowers. The new era of prosperity went on until February 1893, when the Philadelphia and Reading Rail Road abruptly declared bankruptcy. Wall Street grew nervous again, and fretful investors cut back. The economy worsened. Bank runs began. European speculators, fearing the worst, demanded payments in gold, depleting Fort Knox. Three prominent railroads—the Northern Pacific, the Union Pacific, and the Atchison, Topeka and Santa Fe—all failed.


Once again, the specter of unemployment hovered over the land, and many middle-class families defaulted on their mortgages. Real-estate values dropped precipitously. Great Victorian-style houses, a sign of prosperity only a few years earlier, now stood dark and empty. Labor unrest made things worse, as workers struck in the silver-mining towns of the West and a Pullman strike further weakened the railroads and, in turn, businesses that depended on freight deliveries.

http://www.city-journal.org/2009/nytom_urb-booms-and-busts.html

Sound familiar? Especially that last bit? You can substitute other businesses for "railroads" but things really aren't that different today.