Why inflation is necessary

May 20, 2021 by Lauren Hua

Rising inflation causes alarm among investors. So far in 2021, the media has been
saturated with talk of rising inflation as share markets have gyrated wildly. However,
the truth is that inflation is necessary for a healthy economic environment. The RBA
tries to maintain an inflation target of 2-3 per cent to keep the economy growing. In
this article we discuss what inflation is and why it is necessary.

What is inflation?
Inflation is the general rising of prices. This means that goods and services cost
more for the consumer. Hence when inflation occurs the cost of living becomes more
expensive and households have less money to spend on non- essential items.

Why is inflation necessary?

Inflation is necessary and because of this, central banks want to avoid deflation. This
occurs when the price of goods and services is falling. When this happens,
consumers avoid buying products now and plan to buy at another time in the future,
thinking that the price will continue to fall. When consumers withhold their purchases
until a future date it causes a chain reaction as companies will experience revenue
downturn when sales decline. Redundancies and wage reduction can follow when
companies see falling revenues. A rise in unemployment can exasperate the
situation as household spending will be further tightened. Deflation can lead to
recessions and depressions.

A little inflation is optimal for the economy. The inflation target is 2-3% to keep a
healthy economy.  When there is a small level of inflation, consumers are
encouraged to buy goods and services now because they think the prices will be
higher in the future. As demand increases, so does company revenues. This in turn
leads to companies expanding their business by, for example, opening more stores
and hiring new people. So growth is good for the economy but too much growth too
fast will cause the RBA to think about raising rates.  The central banks will look to
slow the economy down if they see the inflation being too high as high inflation
erodes the purchasing power for consumers. High interest rates are a negative for
the stock market as debt obligations would increase when the interest rates are
hiked which can slow the company’s growth. So far there is an expectation of
moderate rises in inflation, which means there are no signs yet of dramatic interest
rate rises by central banks.