How Can Inflation Be Good for the Economy?

Inflation is and has been a highly debated phenomenon in economics. Even the use of the word "inflation" has different meanings in different contexts. Many economists, businessmen, and politicians maintain that moderate inflation levels are needed to drive consumption--operating under the larger, overarching assumption that higher levels of spending are crucial for economic growth. The Federal Reserve typically targets an annual rate of inflation for the United States, believing that a slowly increasing price level keeps businesses profitable and prevents consumers from waiting for lower prices before making purchases. There are some, in fact, who believe that the primary function of inflation is to prevent deflation.

Others, however, argue that inflation is less important and even a net drag on the economy. Rising prices make savings harder, driving individuals to engage in riskier investment strategies to increase or even maintain their wealth. Some claim that inflation benefits some businesses or individuals at the expense of most others.

You may hear the term "inflation" used to describe the impact of rising oil or food prices on the economy. For example, if the price of oil goes from $75 a barrel to $100 a barrel, input prices for businesses will increase and transportation costs for everyone will also increase. This may cause many other prices to rise in response. However, most economists describe a subtly different effect when they talk about inflation. Inflation is also a function of the supply and demand for money, meaning that producing relatively more dollars causes each dollar to become less valuable, making the general price level rise.

When the economy is not running at capacity, meaning there is unused labor or resources, inflation theoretically helps increase production. More dollars translates to more spending, which equates to more aggregated demand. More demand, in turn, triggers more production to meet that demand.

Famous British economist John Maynard Keynes believed that some inflation was necessary to prevent the "Paradox of Thrift." If consumer prices are allowed to fall consistently because the country is becoming too productive, consumers learn to hold off their purchases to wait for a better deal. The net effect of this paradox is to reduce aggregate demand, leading to less production, layoffs and a faltering economy.

Inflation also makes it easier on debtors, who repay their loans with money that is less valuable than the money they borrowed. This encourages borrowing and lending, which again increases spending on all levels. Perhaps most important to the Federal Reserve is that the U.S. government is the largest debtor in the world, and inflation helps soften the blow of its massive debt.

Economists once believed in a real inverse relationship between inflation and unemployment, and that rising unemployment could be fought with increased inflation. This relationship was defined in the famous Phillips curve. The Phillips curve was largely discredited in the 1970s, however, when the U.S. experienced "stagflation," or high levels of inflation and rising unemployment at the same time; thought to be impossible at the time.