Do we really need inflation?

First, here is the definition of inflation provided by Wikipedia: In economics, inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money.

Have you ever wondered why world banks seek to keep the inflation rate around 2 percent? After all, this phenomenon has a negative impact on our purchasing power. It erodes the value of our money. Why do we need 2 percent inflation to keep an economy healthy? Why not set an objective of 0 percent, where prices would remain stable and constant?

In theory, a world without inflation sounds perfect; in practice, however, it doesn’t work. Economic forces are based on expectations and, rightly or wrongly, inflation and deflation create expectations that diverge considerably from one another and that can have a significant impact on the present.

It’s a bit as if our central banks had to choose the “least bad” situation. Inflation is not necessarily a good thing, but it is certainly less harmful than deflation. Deflation leads to a negative spiral of decreasing prices, which slows the spending of consumers as they wait for prices to drop even further. Decreased prices result in layoffs, which result in even lower spending, thus creating an endless spiral that slowly destroys the economy. Deflation had significant negative consequences during the Great Depression.

Of course, there’s also the other side of the coin—just ask the people in Argentina, where inflation rose over 50 percent in the last year. That is not a desirable situation either. However, controlled inflation fosters stronger prospects for the economy.

It is, among other things, because of the inflation after-effect that people do not hide their money under their mattress. Inflation reduces purchasing power exponentially. For instance, $1000 from the year 1900 would have a purchasing power of barely $50 today. It’s important to take some risk in our investments in order to retain at least the purchasing power of our money… net of taxes!

If the Bank of Canada lowers its key rate in the near future, you will know that part of the reason is no doubt to keep inflation under control, and a bit of inflation is the lesser of two evils when it comes to price stability!



The information contained in this article was prepared by Sylvain Lapointe, an investment advisor with PEAK Securities Inc., and was obtained from sources we deem to be reliable; however, we cannot guarantee that such information is complete. The author may not be held accountable for any financial decision a reader may make based on this content. The opinions expressed herein do not necessarily reflect the views of PEAK Securities Inc. PEAK Securities Inc. is a member of the Canadian Investor Protection Fund.