Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Appreciating two benefits of inflation

Even the most awful thing can have benefits – the proverbial silver lining. Your football team losing in the Cup semifinals means that you save the exorbitant price of an FA Cup final ticket; the high cost of property in

London means that the capital doesn’t have to endure ‘Brangelina’ joining its ranks; James Blunt releasing a new album means … , means… , no, sorry, can’t think of an upside there.


Economists identify at least two benefits of inflation: allowing otherwise ‘sticky’ prices to adjust and giving policy makers more room for manoeuvre by allowing them to set negative real interest rates.


Adjusting sticky prices

One of the great things about a well-functioning market economy is that prices adjust to ensure that supply equals demand. If a resource becomes relatively scarce, its price rises. Equally, if people’s tastes change and they no longer want to buy a certain good, its price falls. In this way, resources are allocated optimally.

Economists have noticed that some prices are very ‘sticky’ as regards price

falls. A good example is nominal wages. Sadly, sometimes, real wages in

certain industries need to fall, perhaps because the demand for labour has

fallen or the supply of people willing to work has increased. People tend to

fight hard against any fall in their nominal wage (say, from £10/hour to

£9.50/hour), but they don’t seem to care so much if their nominal wage stays

constant and inflation reduces their real wage (wages stay at £10/hour, but

because of inflation this amount now buys less).

Inflation therefore allows the real wage to fall without cutting the nominal wage. This is a good thing, because if a fall in demand for labour occurs, instead of unemployment going through the roof (the likely outcome if the real wage isn’t able to adjust), the labour market is able to adjust and keep unemployment low.

Another good example is house prices – people are very reticent to sell their house for a lower (nominal) price than the price they bought for. Imagine a fall in demand for houses, which dictates that real house prices should fall. In the absence of inflation, nominal house prices would also need to fall. But because nominal house prices are sticky downwards, sellers refuse to reduce their asking prices and buyers aren’t willing to pay over the odds. Net result: the housing market stops functioning well.

If, however, inflation is 2 per cent and real house prices need to fall by 2 per cent, this can be achieved without a fall in nominal house prices. Without inflation, nominal house prices would need to fall by 2 per cent in order for real house prices to fall by 2 per cent!