Why Inflation is important in an economy
Wondering if someone can explain why inflation is important in an economy. I know in the US, we have a target rate of 2% and in Canada they have a target range between 1-3%, with the ideal being 2%... but my question is... why do you even need inflation? What purpose does it serve in the economy. The way I think about it, workers get wages indexed to inflation for simplicity's sake, so why even go through the hassle of setting inflation?
I'm going to take a stab at this: Inflation is the result of quantitative easing (increasing the amount of capital in the money supply) or it can be caused by a raise in prices.
It's actually a pretty debated topic about whether or not 0% inflation is good for the economy. I can recall one reason arguing against 0% inflation: Often times to reduce expenses firms will need to scale back salaries which can be done by off setting inflation -- if I came to you and say I need to decrease your salary by 3%, you are going to be pissed. But if I say we are going to increase your annual salary 3% (meanwhile inflation could hypothetically be 6%, not likely) you are going to be much happier and I will still net that 3% reduction in salary expense.
I'm fairly confident that's the main reason why some economists like the idea of inflation.
One reason I can think of is that inflation gives an incentive to people/companies to spend money, as goods become more expensive every year:
That's true central banks set an inflation target. Previously central bankers used conventional monetary policies to promote growth and create jobs. But QE is a new measure to reach the same targets where interest rates are already at all years low in most of the developed countries. This is a challenging environment for central banker!!
More specifically, inflation is an important economic factor and is very closely followed by pension funds for instance. An increase in inflation should decrease their future liability. it is the case because of the discounting of fixed future payments at a higher nominal rate results in a lower PV. As most of us are aware of, pension funds are one of the major institutional investors in the capital market, so their investment decisions matter. This is simply another reason why inflation is an important number to follow.
At it's simplest, inflation = growth.
It's been a while since macro, but a large reason why Central Banks set an inflation target is to manage the expectations of the market. That way, investors have an idea of where interest rates might go in the future, as well as have the guarantee that measures might be taken to stabilize the economy with monetary policy (ex. QE) if inflation slows down too dramatically or begins to get too high. There's definitely some debate surrounding the value and the effects of setting an inflation target, (so you're definitely not the first or last person to ask!) but I'm not an expert, so I won't get into that.
The assumption is that inflation will lead to growth in the economy. However, it decreases purchasing power of an individual. This is why wage growth is an important element in today's economy.
My thoughts - inflation isn't all that important to a strong economy, rather it is (generally) the by-product of a favorable economy. This Khan Academy video describes an interesting scenario where the money supply increases (QE) and deflation still occurs because of low confidence. I would say strong consumer confidence would be more indicative of a strong economy than 2% inflation (a lagging indicator).
https://www.khanacademy.org/economics-finance-domain/core-finance/infla…
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