Most Americans including politicians, media pundits, conservative economists and policy makers are averse to inflation (increase in prices). In general this attitude makes sense. In fact, in 1970 public opinion considered inflation as the greatest threat to the economy, and President Carter lost his presidency to Ronald Reagan. But sometimes we may face a state of the economy, for example right now, where a little higher inflation may be good for the economy. It should be understood that inflation rate (growth rate in prices) is related to growth rate in money supply, a policy tool of the Central Bank called Federal Reserve System, in short the Fed.
In the current economy inflation rate has been very low for quite some time. Despite warnings by many conservative media pundits and economists, who are critical of Fed Chairmen Ben Bernanke’s expansion of money supply, inflation rate has been between 2 to 3% per year for more than a decade. Therefore the question is, why is it that massive injection of money supply since the Great Recession has not resulted in the rampant inflation feared by many conservative economists and politicians. Professor Paul Krugman, would argue that the economy is in Keynesian “liquidity trap.”
In “liquidity trap”, even at zero interest rates, peoples’ demand for goods is not enough to absorb the supply of goods, and the amount people want to save is more than the amount people want to invest. Hence, in “liquidity trap” monetary policy losses its effectiveness in decreasing interest rates and stimulating demand for consumption goods and capital goods (for example, factories and machines). How to release the excess cash, which businesses and people are holding on to? Given the fact that inflation rate is very low, Professor Krugman and other economists have argued that one way to release the excess cash and stimulate demand is to increase the inflation rate to around 4% percent.
In his book, End This Depression Now, Professor Krugman quotes a study by Chief Economist Oliver Blanchard and his colleagues at the International Monetary Fund in which the authors argue that higher expected inflation rate than it is now would result in negative real interest rates, and it would stimulate more borrowing and hence greater demand in the economy. Real interest rate is the difference between money rate of interest and inflation rate. For example, if the money rate of interest is 2% and the inflation rate is 4% then the real rate (real cost of borrowing) is approximately negative 2%. Since the threat of higher money interest rate due to inflation is minimal in “liquidity trap”, real cost of borrowing will be negative, hence consumers and businesses will pay back their loans with cheaper dollars. Higher inflation rate will also reduce the real value of the debt overhang – the excessive private debt (including mortgage debt) that is partly responsible for the slow growth of the economy. This would also contribute to increase in demand due to the rise in asset (wealth) values.
A novel proposal on inflation policy is made in a recent study by Juan Pablo Nicolini et al (working paper 698) of the Federal Reserve Bank of Minneapolis. They propose a Fed policy to increase the inflation rate in consumer prices, but not in producer prices. They argue that increase in producer prices would cause inefficiencies in the allocation of resources and lower output in the economy. But they recommend that such an inflation policy be accompanied by gradually decreasing taxes on labor earnings presumably to encourage work and maintain purchasing power while increasing taxes on consumption and temporary investment tax credit to offset some of the distortions caused by consumption taxes. Such a policy, they claim, would result in getting the economy out of stagnation.
The only problem with the Minneapolis Fed’s proposal is that the federal government has to introduce another type of tax – called consumption tax. In the absence of such a tax on the books it does not seem likely that there is political support for a new tax. However increasing inflation rate beyond the current target rate of 2% remains the most practical and economically feasible policy for the Fed to stimulate demand and the economy. In addition, it is hoped that the Congress and the President would complement the Fed’s action by agreeing upon a sound fiscal policy that provides stimulus to the economy in the short run and at the same time puts the budget deficits and public debt on a sustainable long run path.