18 Dec 2019
Is inflation even necessary? Why can't the government just make it 0% inflation?!
That's a good question!
Shouldn't the government be reducing inflation to 0%? That way, we won't have to spend so much money on stuff what!
Well... Yes, and unfortunately, No.
I'm going to explain why inflation is important using something we're all familiar with: ice cream.
TL;DR: Why Is Inflation Needed In Our Economy?
Many economists, businessmen, and politicians believe that inflation, or the gradual increase of prices over time, helps keep businesses profitable and prevents consumers from simply waiting for lower prices before making purchases.
On the other hand, rising prices also makes doing stuff like saving money harder. It causes individuals to engage in riskier strategies in order to increase or just to maintain their wealth.
And as with anything that is remotely linked to the government, people are sure to suspect that inflation is just an excuse for some businesses or individuals to benefit at the expense of others.
Imagine that it's after school. And there are 10 kids who all love ice cream.
The ice cream uncle standing outside school, only has 5 servings left in his cart. And he is selling them at $1 each.
Each kid has $2 in hand and all of them want to have ice cream. The enterprising uncle realises that he can get more for his ice cream so he jacks up the price to $2.
This $1 increase is a result of Demand Pull Inflation or excess demand of a scarce good.
The next day, the uncle heads to the ice cream factory to get a restock of ice cream. The supplier informs him that milk prices have increased, so he is selling 10 blocks of ice cream at $100 instead of $80.
The ice cream uncle knows that he gets 200 servings of ice cream from 10 blocks. And this $20 increase means that if he wants to make the same profit, he must now sell his ice cream at $1.10 instead of $1.
This is a result of Supply Push Inflation, which is caused by a substantial increase in the cost of important goods or services where no suitable alternative is available.
After all, he can't make ice cream out of water right? So bobian, he has to buy the product in order to make a living.
Inflation In The Real World
When everyone in an economy is expecting say... A 10% inflation, everyone adjusts their prices upwards by 10%. Suddenly your pint of milk costs $1.10 (from $1), your loaf of bread costs $3.30 (from $3), and your McSpicy meal costs... Well, you get the picture.
This was EXACTLY what happened in the States during the 1970s where everyone expected double digit inflation due to high oil prices.
In fact, people started factoring this inflationary expectation into their wages and prices of goods. Unfortunately, this expectation was allowed to develop and continued without significant economic growth which resulted in Stagflation.
The result? Unemployment rates rose to an astronomical high and the US economy went into a recession.
The world has learnt from this mistake though.
So as a result, governments try to limit inflationary expectations by stating outright what the target inflation rate for the year is. This is why you'll notice that MAS makes a huge point every end of the year to announce what the target inflation rate for the next year will be.
It'll usually be a sustainable and healthy level of inflation. Not high enough to turn your cash savings into "banana money" (read: currency used during the Japanese occupation which became worthless due to inflation).
But high enough to create a sufficient buffer before deflation happens.
Asset Bubbles: The Calm Before The Deflation Storm
Asset Bubbles occur when Demand Push Inflation causes assets to become overvalued.
Let's say all the cool kids at school think that having an ice cream after school is the trendy thing to do. The uncle decides to up the cool factor by branding his ice cream with a trademarked logo and prices his ice cream at $10 (remember that it only costs him $0.80 to make one before the supplier increased the price of ice cream).
It's all the rage amongst the kids, and every one at school is either begging their parents to get them this "branded" ice cream or are saving up their pennies just to buy one.
One day, the popular kids are sick of the uncle's ice cream and refuse to even pay cost price for the ice cream.
The asset (ice cream) bubble has just burst, and what follows is deflation.
Cue (ice) screams
Sorry, couldn't help it.
The Problem Of Deflation
Remember the 10 kids who used to buy ice cream from the uncle? They all still have $2 to spend, but they're no longer interested in spending it on ice cream because it's not trendy anymore.
Instead, they're buying Korean instant noodles because that's what all their K-Drama idols are eating.
On Monday, the uncle sells his ice cream at $1. The next week, he drops it to $0.90 because the kids still aren't buying.
A month in, he drops it to $0.80 out of desperation.
Some of the kids start to wonder if they should have ice cream, because it's cheaper at $0.80 now. But they also can't help but wonder if it'll drop to $0.50 and that's when they can have 2 ice creams for the price of one.
"Shiok! Deflation is great! I can buy 2 ice creams sia..." Gerald, one of the kids, exclaims.
A couple of months later, 90% of ice cream uncles in Singapore can't afford to keep their carts because they can't pay for the ice cream distribution license. Gerald's dad, who also happens to be an ice cream uncle loses his job.
And guess what? Gerald now has no pocket money for ice cream or Korean instant noodles...
Inflation is a 'necessary evil' that helps keep the world economy functional.
If you're concerned about inflation eating up the value of your dollar, Seedly has a great piece written on why investing can help you to overcome inflation. Do check it out.
In order to have inflation, 2 things must happen:
To make inflation 0% means having constant money supply and no velocity of money, which is not possible because:
You may watch the following video about The Gold Standard vs Fiat Money to understand more about monetary history:
Hmmm perhaps the answer need not be on a factual level but on a literal level to your question.
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