What’s in This Chapter?
Inflation is an important factor influencing a nation’s economic health. Low inflation means more price stability and more certainty for households that their savings and investments retain their value, and more certainty for businesses that their investments will yield a positive return in the future. This increases incentives to invest and produce.
Low inflation increases consumer and business confidence in the future value of the currency. People, therefore, have more incentive to save. Greater savings leads to more available funds in the financial markets. This leads to lower interest rates, which encourages increased businesses expansions, investments, and innovations.
Low inflation relative to other countries’ inflation rates, ceteris paribus, means lower prices in comparison to foreign goods. This makes our products more competitive and increases our exports.
So what is the secret to avoiding inflation? The answer: Keep the nation’s money supply constant or nearly constant. Many people believe that in order to achieve economic growth, the money supply needs to increase. This is a misconception. With low inflation, reasonably low taxation, reasonable regulations, and a government that provides the essential services listed in the previous units, a constant money supply environment will lead to rising production. If the money supply remains constant and production increases, the nation’s average price level falls. Contrary to popular belief, falling prices – especially if it is due to increasing aggregate supply – is a healthy economic condition. Even falling housing prices are beneficial as long as they are gradual and consistent and caused by advancements in technology and cost improvements. Some economist fear that banks will suffer when housing prices fall. However, as explained in more detail in this unit, banks faced with consistently falling housing prices will be profitable and healthy as long as they have responsible lending practices (require a down payment and structure their loans so that the loan amount decreases each year).
When a nation’s money supply remains constant relative to population growth, total nominal income will remain constant. However, increased production means lower prices, so real incomes, real wealth, and real profits increase. This unit elaborates on these ideas and shows that we can have an expanding economy with falling prices and continuing prosperity without artificial monetary stimulation.