Why should the inflation rate not be maintained at zero?

Answer 1

Maintaining an inflation rate at zero might seem appealing since it suggests price stability, but several economic arguments highlight why a zero inflation rate is not necessarily desirable. Here are some reasons:

1. **Wage Rigidity:** In the presence of zero inflation, nominal wages must often be cut to adjust to economic downturns, which is difficult due to wage rigidity (the resistance of workers to accept nominal wage cuts). A moderate level of inflation allows real wages to adjust downward without needing to cut nominal wages.

2. **Monetary Policy Flexibility:** Positive inflation gives central banks more room to maneuver with interest rates. If inflation is zero, nominal interest rates are also likely to be low, limiting the central bank's ability to cut rates (since rates cannot fall below zero, the "zero lower bound" problem) when stimulating the economy is necessary.

3. **Deflation Risk:** Maintaining a zero inflation target increases the risk of deflation if the economy experiences negative shocks. Deflation, or falling prices, can lead to decreased consumer spending (as people delay purchases in anticipation of lower prices), reduced investment, and increased real debt burdens (because the real value of debt increases as prices fall), which can stifle economic growth.

4. **Encouragement of Spending and Investment:** A moderate, predictable level of inflation encourages individuals and businesses to spend and invest rather than hoard money. This type of expenditure is necessary for economic growth.

5. **Measurement Difficulties:** Inflation is hard to measure perfectly. Aiming for zero inflation leaves little room for measurement errors and might inadvertently lead to deflation. A modest positive target (such as 2%) provides a buffer against these errors.

6. **Debt Sustainability:** With moderate inflation, the real value of debt decreases over time, making it easier for both private individuals and governments to manage and reduce their debt burdens. Zero inflation doesn't provide this benefit, making debt more onerous to service.

In light of these considerations, most central banks around the world strive for a low but positive inflation rate, often around 2%. This level of inflation is seen as a compromise that balances the need for price stability and the practical economic benefits of having some inflation.