High inflation has often been considered harmful to the economy. However, it is deflation which can be more harmful to the economy. Economist John Meynard Keynes believed that some inflation was needed to encourage consumers to spend and prevent the paradox of thrift. The paradox of thrift is detrimental to the economy. This is because savings prevents consumers from spending and the economy from growing.
Deflation can be a bad for the economy
Deflation occurs when all prices fall. Simultaneous falling prices can impact the economy negatively. When consumers can see the price of goods falling, they don’t buy now. They think it will go down further so they wait to see if the price of that good will fall further. Companies then cut prices further as they want consumers to buy. This reduced demand causes lower revenue for firms. This can then lead to redundancies, pay cuts, and other cost cutting measures. If firms start reducing wages to cut costs, then employees would find it difficult to pay off existing debt. As the result of the wage cuts, homeowners will find a bigger portion of their salary to allocated to paying off their loans which means they are left with less money for goods and services. This can create a chain reaction where people may default in their home loans which will then lower house prices.
Companies are reluctant to expand and hire more people when sales are low. Therefore deflation prevents the economy from growing.
A bit of inflation is healthy as is it helps increase incomes, the economy to grow, tax revenues to increase, and level of living standards to increase.
Deflation is also bad for the share market as poor company profits causes share prices to head lower.
Deflation can therefore lead to recessions and depressions.
Problems with high inflation
High inflation reduces the purchasing power of money. Inflation can create problems for retirees and savers. For retirees, high inflation may erode the purchasing power of their lump sum. With savers, if the interest they have been generating on their bank account is less than the rate of inflation, then they have less purchasing power.
Inflation causes higher purchase prices on goods and services for consumers. As the cost of production increases, firms pass this onto consumers. Banks also raise their mortgage rates because interest rates have been raised by the central bank to lower the high inflation. These rate rises will be passed on to borrowers which will also cause more tightening of the household budget.
Low inflation is key
The RBA tries to maintain an inflation target of 2-3 per cent. This small change in consumer prices will encourage consumers to buy now and not wait for later. This keeps businesses producing services and products and keeps the economy growing further.
Lauren Hua is a private client adviser at Fairmont Equities.
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