Tag Archives: Fed

Ask an Economist: Why do prices have to go up?

Why is it inevitable that prices go up? In other words, why do we just /assume/ that it makes sense for everything to cost twenty (or so) times today what it cost a hundred years ago?

In theory, the Fed could try and manage the money supply in a way that tries to hit a 0 percent inflation mark. But there are lots of problems with this, and aiming instead for a 2 to 2-and-a-half rate arguably has advantages.

First, it’s important to realize that managing the money supply with regard to inflation is an imperfect science. It’s like trying to steer an aircraft carrier looking out of a warped and blurry porthole. It takes months to turn the ship, CPIand you’re never sure of what ahead or what the currents really look like. Even with some of the best macroeconomic minds in the business working on this full-time, it’s impossible to anticipate everything that could happen.

A big problem with aiming for 0 percent inflation is that there’s a big risk that at some point you’d have deflation, when prices are actually decreasing. This might sound like a good thing, but it’s actually traumatic for an economy – just ask Japan. If consumers believe that prices will be lower next month than they are today, they delay purchases – which can lead to even more deflation. When 70 percent of GDP is driven by consumers, this can be devastating for the economy and lead to prolonged recessions and higher unemployment.

Another point to remember is that when average prices are rising by 2 percent a year, some prices are rising much more, and some are actually falling. This is always the case. The inflation numbers reported in the news are just the overall, Price Changes by Categoryweighted averages for urban consumers. There’s always actual deflation occurring in some product categories, and depending on what you buy, the average prices you pay could actually be decreasing overall.

There’s also an (arguable) advantage to having prices increase by 2 or 3 percent a year. This allows employers to give some workers pay cuts by holding their (nominal) wages constant. This actually can be helpful to the economy in declining industries, or with poorly-performing workers. It’s very difficult to give employees actual (nominal) pay cuts, even when it’s necessary and appropriate. Having inflation allows employers to freeze wages and give employees (real) pay cuts. The workers know what’s happening, of course, but they’re less likely to riot than they would be if their nominal wages were cut.

Finally, having low, steady rates of inflation do very little harm to an economy. Borrowers, lenders, firms, consumers, and everyone else expects prices to rise by small amounts, and they build them into prices, contracts, and decisions. The small “menu costs” involved with changing prices every year or so are a small price to pay for the relative advantages of having low inflation.

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