Why are slowly increasing prices considered stability?

October 4, 2012 12:29 AM

Why do most central banks target a small non-zero inflation rate rather than zero? - Bank of England target is 2% CPI - European Central Bank HICP target is "less than 2%" - US Federal Reserve target is 2% Why don't they all target zero if the ultimate aim of policy is actually "Price Stability" as most officially state.

Secondly is this background level inflation a relatively modern 20th Century thing? I have seen suggestions that during the 19th Century general inflation was essentially zero (in the UK at least). ie that the effective purchasing power of £100 was much the same in 1900 as it had been in 1800.

Was there generally inflation during the Roman Empire? Or say China or Mesopotamia? Can you recommend any books on historical inflation? or a History of Inflation / Prices

posted by mary8nne to work & money (12 answers total)

Zero inflation or deflation is not generally desirable because it gives people incentive to hold on to their money rather than spend or invest it. This acts as a drag on the economy. A small rate of inflation means that by putting your money under the mattress, it is gradually losing value. It would be better for you to spend it, or lend it out, spend it on capital paying a return, etc, and this is better for the economy.

By price stability, they really mean, that prices are predictable over time. Central banks target a low, but primarily predictable level of inflation each year.

There was definitely historical inflation, for example from the Wikipedia article on inflation:
During the Mongol Yuan Dynasty (12th century), the government spent a great deal of money fighting costly wars, and reacted by printing more, leading to inflation.[20] The problem of inflation became so severe that the people stopped using paper money, which they saw as "worthless paper."[19] Fearing the inflation that plagued the Yuan dynasty, the Ming Dynasty initially rejected the use of paper money, using only copper coins. The dynasty did not issue paper currency until 1375.[19]

However in the past, money was typically tied to a commodity like gold or silver - and hence limited in supply for good or worse. Once those links were removed, money supply could be more responsive - but also there was more chance of massive inflation.
posted by dave99 at 1:33 AM on October 4, 2012 [4 favorites]

A good starting point to your first question is this speech by Ben Bernanke, which explains why deflation is bad and why you want a small buffer zone of inflation to prevent it:

... the Fed should try to preserve a buffer zone for the inflation rate, that is, during normal times it should not try to push inflation down all the way to zero. Most central banks seem to understand the need for a buffer zone. For example, central banks with explicit inflation targets almost invariably set their target for inflation above zero, generally between 1 and 3 percent per year. Maintaining an inflation buffer zone reduces the risk that a large, unanticipated drop in aggregate demand will drive the economy far enough into deflationary territory to lower the nominal interest rate to zero. Of course, this benefit of having a buffer zone for inflation must be weighed against the costs associated with allowing a higher inflation rate in normal times.

In answer to your second question, a good example of problems with inflation in a Roman context is the Edict on Maximum Prices. Coinage reform was a rite of passage for many Roman emporers.
posted by kithrater at 1:47 AM on October 4, 2012 [2 favorites]

0% is not really possibly since supply and demand will never be universally balanced everywhere. It's also too close to deflation, and risky. More info.
posted by blue_beetle at 1:56 AM on October 4, 2012

2% inflation isn't actually small; it gives idle wealth a half-life of about 34 years, or (coincidentally?) about one human generation in rich modern societies.
posted by cromagnon at 3:48 AM on October 4, 2012 [1 favorite]

There is sort of a bigger embedded question here about fiat money vs convertible money and what causes inflation. An argument this is not the right place to have. But at this point the general consensus is that a little inflation is better than no inflation or high inflation, so the fact that inflation in the 19th century was low (off the top of my head I have no idea if this true BTW - I don't think it was given how much debt the UK govt took out to finance the Napoleonic Wars actually) would be a bug not a feature.
posted by JPD at 5:22 AM on October 4, 2012

The federal reserve has some influence over the rate of inflation when it is positive, but at zero or negative (deflation) they have no influence. To a free market advocate this is encouraging, but it explains some of it.

Historically inflation sometimes occurred with coins when an edict would come to restamp coins with the imprint of the new monarch. Typically coins were clipped or trimmed in some fashion during the conversion so that the amount of precious metal in the new coins was less than what was turned in for conversion.

The original meaning of "a dollar" was 1/20th of an ounce of gold, just to give an idea how much inflation has occurred to US currency.
posted by dgran at 5:24 AM on October 4, 2012 [1 favorite]

There is no floor or ceiling on price fluctuation. (*)

And it really, really, really sucks when you get even a little bit off of the 1-2% inflation range, in the system we have right now.

This is like trying to shoot at a round target with a gun that tends to go a bit too far to the right - the instructor says "try to aim a little bit too far to the left" rather than saying "try to aim so far over to the left that you can't even hit the target" because the gun is only a little bit off.

Similarly, in a normal, healthyish fiat money system, in a fully industrialized society, prices want (for a variety of reasons) to go a little bit up over time.

Have I mentioned there are fragile things, or people, or whatever, on either side of that target we're shooting at? It's like in Star Wars - either Luke hits the target or Grand Moff Tarkin blows up Yavin IV.

There's a theory that the real problem in the Great Depression was actually debt deflation - the value of debts (anything that has to be valued in monetary terms; stuff owed to banks and such) was increasing while the value of physical stuff and labor (which can be valued in terms of other physical stuff or labor) stayed more or less constant or actually fell.

In such a scenario, people stop working for money (either because no one can afford to pay them enough to buy things/pay off debts, or because it's easier/more possible to work in exchange for goods directly - c.f. To Kill a Mockingbird, where Atticus is working as a lawyer but getting paid in produce,) debts grow (in relation to how much work/value it takes to pay them off,) physical items are sold for less than they're worth, people start hoarding physical items and delaying purchases, everyone is very pessimistic, etc. The key line from Fisher is, I think:

[T]he more the debtors pay the more they owe

Deflation is often (per the theory) seen as an after-effect from too much economic expansion (such as after a huge war or credit bubble or whatever) - this kind of fear preoccupies the time and thoughts of most central bankers these days, if you can believe the way they talk; it's always the pendulum swing from whatever is happening now that most alarms them. This is what they mean when they say they want price stability - they want prices to be super, super predictable, as dave99 says.

Some argue that the problem is caused by all the obsessive meddling in the money supply, but we've definitely in "oh crap an argument on the Green" territory there.

This is such a "tip of the iceberg" kind of thing it's rather difficult to explain just one answer without creating five new questions and/or getting into a rather fighty place.

(*) Compare temperature ratings, with "absolute zero," or measuring an angle, which is never really more than 360 degrees - you can have 297,000% inflation, and you can have ridiculous deflation, and it can always get worse; I would have used the biggest number on the current list of worst examples, but I can't remember how to do the HTML for superscript for the scientific notation. In general, the numbers for inflation get ridiculous much faster than those for deflation, but the effects of deflation are observably awful at rates very close to zero, so.
posted by SMPA at 7:20 AM on October 4, 2012

The above explanations are correct; I just want to note that a small amount of inflation also slowly reduces the size of your existing debt relative to the economy.
posted by Homeboy Trouble at 8:05 AM on October 4, 2012

Agreeing with nearly everything here. Except the idea that inflation transfers wealth to the 1%. Inflation reduces the value of money. If you have "extra" money, your purchasing power goes down. Your investments have a yoke around their necks- they have to match inflation to break even. Meanwhile, if you OWE money, its value goes down in relation to current earning power.

Think of inflation (and deflation) in terms of money supply. If my boss promises to pay me $25,000 a year, my boss has to be able to get his hands on $25,000, every year. My boss's customers have to be able to get their hands on some money to be able to buy the products being sold. And so on and so on in a big circle. (The circle is the big concept to understand in macroeconomics.)

Now, in an imaginary world where the supply of money is fixed and the population is fixed, you would expect that an equilibrium would take place. Prices and wages would stabilize. But what really happens is that populations expand and contract, products come into and out of popularity or season, disasters knock down houses that need to be rebuilt, and so on. This "noisiness" in the system combines with time to create oscillations in prices and money supply. It is a complex, dynamic system. These fluctuations get amplified and damped by natural market forces like saving, lending and borrowing.

So a central bank tries to dampen out those fluctuations, by adding to or subtracting from the money supply so that at any given moment, the supply of money more closely matches the actual demand.

And they have figured out that while people merely dislike inflation, they go crazy when there is deflation. Putting it another way, people react to inflation by trying to become more productive. They are motivated to earn because they have to spend. Whereas people react to deflation by hoarding. They are motivated to not spend because they can't earn.
posted by gjc at 8:27 AM on October 4, 2012

A low level of inflation has a bunch of positive effects, especially when coupled with population growth. People are inclined to take the risk of loaning out money, instead of just hoarding it. Businesses are encouraged to invest their money in new equipment, or research, instead of just sitting on it. In addition, most modern monetary policy involves manipulating interest rates, but if interest is at 0, you can't lower it any more (See Liquidity Trap). Also, deflation is horrific, and really difficult to control once it gets going.

As for historical inflation, yes it is a thing. Notably, the Song dynasty, the first to issue fiat currency, were also the first to figure out that it didn't play by the same rules they were used to. The Yuan dynasty had some hyperinflation problems, if I recall. Romans had inflation problems, stemming partly from adulterated coinage. I think the most interesting case the the inflation in Europe from the late 1400's to the 1700's from the glut of silver and gold coming over from the Americas.
posted by Garm at 9:15 AM on October 4, 2012

One other thing to keep in mind, in addition to other excellent things people have mentioned; our measures of inflation are not perfect, and in fact may be biased upwards (CPI has a fixed good basket as a baseline, for example, which may not take substitution effects or quality changes into account). So slowly increasing CPI may not really mean that material prices people are paying are going up quite so fast.

There is a whole line of macro research that looks into optimal price targets for central banks that generally supports the one to two percent range for the reasons outlined in some of the answers (particularly, the zero lower bound problem).
posted by dismas at 12:24 PM on October 4, 2012

It makes sense for a store of value to face inflation, because the preservation of a society's wealth is not free. The sum of human knowledge and useful physical objects that wealth consists of require maintenance: buildings have to be kept up, roads need to be maintained, knowledge needs to be passed from one generation to the next and more sought out. Rather than allowing a person to store wealth as currency indefinitely for free, when they can't do the same for food or a house or other forms of physical wealth, inflation motivates them to do something with their money that increases total societal wealth, or put it in the custody of someone who will do so.
posted by akgerber at 4:34 PM on October 4, 2012