Sunday, November 22, 2009

What is "good" inflation?

Any price inflation that is an outcome of consumer preferences should be construed as good. According to economist Joseph Salerno, there are two kinds of benign inflation:

1. Innovations that permit people to economize on the amount of money they hold in their cash balances brings about a decrease in the demand for money, which in turn tends to raise prices, all other things being equal. Credit cards, for example, enable people to make purchases without drawing down their cash balances. By increasing the demand for goods without a corresponding increase in the money supply, price inflation results.
. . . cash-economizing inflation is benign precisely because it is an outcome of individuals striving to optimize their property holdings through the voluntary exchange process. It is also noteworthy that this kind of inflation involves a one-shot increase in prices: once the new payment method or invention becomes broadly adopted, the decline in the demand for money ceases and prices stop rising. Lastly, inflation caused by people responding to opportunities to economize on their money holdings has no systematic effect on credit markets and the interest rate and therefore does not precipitate the business cycle.
2. A second type of "good" inflation comes about when the supply of goods and services is reduced because of natural disasters, the depletion of natural resources, increases in people's preferences for leisure (which means fewer people are working), or an increase in demand for present consumer goods (which means capital goods are not replaced). In any case, an excess demand for goods has emerged from a reduction of their supply. With a constant stock of money prices will tend to rise.
Once again we note that, unlike the ongoing price inflation that is typically caused by central-bank expansion of the money supply, the inflation generated by diminished supplies of goods is a one-shot affair. Prices stop rising as soon as the supplies of goods and services stop decreasing and stabilize at the lower level consistent with the change in the economic data.

"Scarcity" inflation is thus socially beneficial because it facilitates economic calculation and smoothly operating markets in a situation in which people's preferences or their production opportunities have undergone a radical change. History has shown time and again — during wars, revolutions, sieges, and crop failures — that any attempt to repress scarcity inflation via price controls or centralized distribution of necessities results in calculational chaos, widespread poverty, and social disorder.

Our conclusion is, thus, that a rise in general prices driven by the demand for money always improves economic welfare as Austrians understand that term.

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