Lesson 2, Topic 13
In Progress

13. When does inflation rise? And why is deflation a problem?

Lesson Progress
0% Complete

Inflation means that money loses value, or in other words, that goods and services become always more expensive. One typical situation that leads to inflation is when demand rises more than the quantity of goods and services available. The money supply is only one of several factors involved. It also depends on how much money people save. As long as the money supply increases, while people simply hoard the additional money in their accounts and do not spend it, nothing happens. Just as important is whether the production of goods and services increases or decreases. If the production of real values increases in tandem with the money supply, the value of money remains stable.

Leaving external shocks aside for the moment, inflation occurs in boom times, when production reaches its limits because all factories are working at full capacity and full employment prevails. Then wages rise, which drives prices up. In such cases, the central bank tries to slow down the banks’ money creation by means of its key interest rate. A high interest rate aims to discourage companies and private individuals from taking out more and more loans in the boom situation. In fact, it is the banks’ own money creation that increases automatically in good times and therefore tends to have an inflationary effect.

The state basically has two ways of reacting to inflation and reducing demand: first, the central bank can raise interest rates sufficiently to reduce the demand for credit and, thus, the commercial banks’ production of giral money. In an overheating economy, where considerable credit is demanded and invested, raising the key interest rate can cool things down. But the central bank must proceed cautiously so as not to trigger a recession by stepping on the brakes too hard. Modern Monetary Theory points out that excessive demand can be reduced more sensibly by raising taxes than by raising interest rates. But even here, the government must consider the risk of a collapse in demand.

The dangers of a recession must not be underestimated by any means. For when unemployment rises, demand soon collapses. Since there is less demand, less is produced and even more people are fired. The problems of too little demand and unemployment are mutually reinforcing. This case is usually accompanied by deflation. Prices are lowered to find consumers willing to purchase and falling prices make production even less profitable. Deflation, once it starts seriously, leads to a downward spiral against which the central bank’s key interest rate will be powerless. For where demand and profits no longer exist, even a loan at zero interest is too great a risk for a company. In such a situation, households, companies, and banks save and thus exacerbate the situation. Now it is only the government that can save demand and the labour market. Since the state does not have to make a profit, it does not have to pay back its debts and is therefore the only one that can act anti-cyclically and swim against the tide.

But now we are experiencing inflation that is not driven by rising investment and rising wages, but by external shocks. The Corona crisis and Ukraine war have affected global production and supply chains, so that fewer goods and services are available. During the Corona crisis, states have expanded their money creation to cushion the recession and avoid unemployment. Now, the states need and create additional money for the Ukraine crisis. Global demand has thus potentially increased. In addition, the Ukraine war is pushing up one of the most important prices – that of energy. Some increase in inflation seems inevitable in this situation. This is because external circumstances prevent production from adjusting to demand by expanding. The current inflation situation is based on global events and price developments that Western central banks cannot change. There is therefore a high risk – especially in the fragile Eurozone – of triggering a recession by raising key interest rates without solving the inflation problem. In the end, the government could be forced to create and distribute even more money to avoid social hardship.

It is important to realise that in certain situations moderate inflation can be the lesser evil compared to a severe recession. For while inflation mainly threatens savings, recession threatens labour income, which is the more crucial factor for most people. While the purchasing power of labour income is also reduced by inflation, there is the possibility of targeted support for those who can no longer afford the cost of living due to rising prices.

Fundamentally, the current inflation is about too much demand for resources that have become scarcer due to international developments. To fight inflation and ensure a fair distribution of what is available, a political cap on consumption is also conceivable, for example by limiting the consumption of fossil energy or relieving the rising grain prices by limiting meat consumption, which of course requires democratic majorities.

On the topic of economic crises see also the article “Economic strategies to manage the crisis: Austerity or government investment programmes?” on this website.

× Chat with us! Available from 10:00 to 18:00 Available on SundayMondayTuesdayWednesdayThursdayFridaySaturday