Low, stable levels of inflation are preferable for economic growth. Inflation occurs when the money supply increases relative to output or the price of goods. Low inflation allows central banks to maintain tighter control over interest rates and encourages investment. High inflation can cause market instability, reduce purchasing power, and slow economic growth.
Inflation and economic growth are related terms with an often contradictory relationship. While the resulting interaction between inflation and economic growth is not always easily predictable, many economists believe that low, stable levels of inflation are preferable to high, unpredictable ones. After more than a century of modern economics, many studies have shown that most economies tend to grow at a faster pace when accompanied by low to moderate levels of inflation. High levels of inflation, by contrast, are usually linked to a variety of problems, including slowed or halted economic growth.
Inflation usually occurs when the money supply increases relative to output or the price of goods. For example, if a hamburger costs $5 US dollars (USD) and a person has $50 USD to spend on lunch per week, he or she would spend 10% of that money on the hamburger. However, if the person gets an extra $50 a week and the hamburger seller raises his prices to reflect this wage increase, the exact same hamburger would cost $10 USD, but it would still be the same percentage of the buyer’s income. In other words, the purchasing power of the dollar decreases, as the increase in money has affected both the buyer’s income and the seller’s prices.
Low inflation and economic growth are often linked for several reasons. First, the existence of inflation allows central banks to maintain tighter control over interest rates. If a recession or depression has caused a central bank to cut the interest rate to zero, they are unable to adjust further if the situation worsens. A low level of inflation ensures that interest rates will stay above zero, giving the central bank the opportunity to cut interest rates as a means of countering an economic slowdown.
Another way that low inflation and economic growth are linked is through the maintenance of price stability. When inflation levels are low, they also tend to be more stable, meaning rapid and destabilizing changes in purchasing power or prices are less likely. Price stability generally encourages investment, as investors feel more confident about the future of the market.
High levels of inflation, by contrast, can sometimes wreak havoc on economic growth. When inflation levels are high, people may hoard goods out of fear of shortages, causing market transactions to slow down and stimulating the real possibility of shortages of essential goods. High levels of inflation can also reduce the purchasing power of the dollar faster than labor markets can respond with wage increases, causing many workers with previously sufficient incomes to suddenly find themselves unable to make ends meet.
Another potential danger of high inflation and economic growth is a growing risk of market instability. Rapid or high inflation can destabilize price levels, making it much more difficult to accurately predict future market behavior. Price destabilization can be extremely dangerous, as investors can become discouraged, thereby slowing the growth of new business investment and stock trading. Furthermore, the unpredictability of high inflation can make it difficult for economists, central banks and governments to devise actionable plans to control or reduce inflation rates.
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