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Marlon Rhodes.
As concerns over COVID-19 have subsided, inflation has dominated the headlines, and for good reason. Persistently and rapidly rising prices beyond expectations can severely hamper economic growth and diminish consumers’ purchasing power, especially when wages and salaries do not rise at the same time or to the same extent as the movement. price inflation. However, despite the challenges that come with persistently high inflation, it is also important to remember why inflation – when it is more subdued and predictable – is important for economic growth. There may also be a main upside to inflation, no matter how fierce, that many of us should be able to appreciate.
The most obvious impact of inflation is that it reduces purchasing power. If consumers are unable to buy as many goods and services as they could before inflation, their standard of living will decline. Rising prices for essential goods would also negatively impact budgets and could also prevent individuals from putting as much money into savings, which could be a setback.
However, under normal circumstances where inflation is more subdued, economists argue that the concept of rising prices is a factor that should stimulate the economy, assuming that increased spending (consumption) as a component of the gross domestic product (GDP) is essential to economic growth. . A good way to explain this argument is to first understand why inflation is theoretically preferred to its opposite extreme, deflation.
In a deflationary environment where prices are constantly falling – and are expected to continue falling – instead of rising over time, consumers may eventually learn to postpone purchases to get better deals. On the surface, and in the short term, this may seem beneficial to everyone. Producers would pay less for raw materials and then pass the lower costs on to consumers in the form of lower prices for finished products. However, as with everything in life, consistently lower prices can come with economic trade-offs, and economists call this particular trade-off the “paradox of economics.”
According to the paradox of thrift, if consumers delay purchases while waiting for better prices, this can have the net effect of reducing aggregate demand in the economy. Moreover, if fewer goods and services are demanded by consumers, producers should eventually learn to make less of what they supply. This can cause a domino effect of declining production within the economy, triggering less need for employees and consequent job losses, resulting in a failing economy as unemployment and competition for jobs leads to accepting lower wages as people desperately seek to earn a living. Wage deflation can lead to consumers having less money to spend, thus leading to a vicious cycle of even weaker demand in the economy and the aforementioned effects. Through this, economists often describe deflation as “self-perpetuating”, and that it is possible that we will all suffer from it, as the paradox of thrift takes effect.
Deflation can also lead to an increase in the real value of debt. Falling prices for real estate and other assets may cause lenders to refrain from making new loans to borrowers, as the value of collateral is expected to continue to fall with deflation, making loans less increasingly risky.
On the other hand, we can now understand how a moderate increase in prices in a predictable way can have a better chance of stimulating economic growth. When prices rise, consumers should prefer to buy sooner rather than pay later. This should lead to an increase in demand in the short term, and as a result, stores sell more and factories produce sooner. They are more likely to hire new workers to meet demand, thereby increasing employment, wages and subsequent expenses. Overall, this creates a virtuous circle, thereby boosting economic growth and making the case for moderate and predictable inflation. The challenge for countries around the world involves the tedious process of maintaining the optimal rate of price increases.
Finally, the silver lining that can come from inflation is that existing loans become cheaper to repay. Fortunately for borrowers, the outstanding principal balance they have on loans such as their mortgages does not increase with inflation. Therefore, when salary increases occur over time, borrowers should find that the true value of their principal balances on loans taken out in previous years has become less costly to repay. This encourages borrowing and lending, again increasing spending at all levels of the economy.
Rising inflation has dampened the Jamaican economy and the wider global economy this year. However, inflation, in and of itself, is not the real beast. It is the large and unpredictable price fluctuations that we should be wary of. We need low, predictable price increases to drive consumer demand that will fuel producer supply and ultimately fuel economic expansion. The challenge for our monetary and fiscal authorities is to strike the right balance between pushing and pulling prices to support long-term economic growth so that we experience an improvement in our standard of living and our quality of life.
Marlon Rhoden is a Research Analyst at VM Wealth Management Limited with a passion for seeing clients build their wealth. He focuses particularly on the bond market and counterparty risk.
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