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Why does inflation matter at all?

Noah Smith argues that inflation has low costs and central banks should therefore sometimes trade-off higher inflation against better GDP performance. And Olivier Blanchard has made the case to raise the inflation target above the current 2%, to increase the distance to the zero lower bound.

Yet in the mind of many people there’s no place for inflation. People have “money illusion”, so they fail to adjust nominal values for overall price changes and feel richer or poorer when really they ‘re not. Inflation is seen as a bad thing and George Akerlof and Robert Shiller write:

Inflation itself, particularly when it is increasing, can ultimately create a negative effect on the atmosphere of an economy, akin to the effect of broken windows and graffiti on a city. These lead to a breakdown in the sense of civil society, in the sense that all is right with the world. (p65, Animal Spirits)

For my bachelor thesis, I read Barry Eichengreen’s “Globalizing Capital”. He explains how modern economies changed after World War I. Larger firm conglomerates and unionization made wages of workers less flexible. And this downward wage rigidity was a problem during the Great Depression.

Nominal rigidities are the reason that monetary policy works at all. If prices and wages were flexible, then when the central bank doubles the money in circulation, all prices would also double immediately. So, I thought, the solution is to index all prices. If inflation from this year to the next is 2 percent, then your wage, your rent and every other price should automatically rise by 2 percent. And if for some reason the aggregate price level falls, then all these prices would also adjust downwards.

But indexing all prices is not workable and people wouldn’t accept it. And because money isn’t neutral, there is a role for intentional monetary policy. One of the most important effects of higher inflation is that, if wages adapt slowly, real wages fall for a while. So it’ll be cheaper for firms to hire people and they’ll be more willing to do so.

Economists are quick to prescribe other people economics lessons, but understanding inflation and the difference between nominal and real values is a basic skill that I wish more people would have.