Of primary importance is the recognition that inflation is not an unnatural or harmful mechanism for a country’s economy. Certainly, from the point of view of an ordinary citizen who pays taxes and gives their private money for goods, it may seem that the absence of pre-election inflation or even deflation are good strategies to curb economic dynamics, and this is something to strive for. In fact, however, such an approach can cause a number of problems.
First of all, this problem concerns the consumer opportunities of citizens. If the Federal Reserve does not manipulate price changes — when inflation is at the zero level — the buyer has fewer incentives to consume. This means that total consumer spending is reduced because there is no change in price offers (Akerlof et al., n.d.). A citizen can give up savings and interest deposits: there is a state guarantee that tomorrow’s prices will be the same. The second consequence of zero inflation is a real increase in demand for goods and services of the U.S. economy, which creates an disproportion between supply and demand. In this case, the company should have increased its production capacity, but with zero inflation, it is problematic (Yellen, 2017). Companies will not be able to afford to hire new employees, and it will be necessary to re-evaluate existing HRs in a stable price environment. Thus, the company’s management will have to cut salaries or fire some of its employees, which will lead to an expected increase in unemployment in the country.
Another consequence of maintaining inflation at 0% will be reducing real interest rates by the Central Bank. In theory, the real interest rate is defined as the nominal one minus the inflation rate, but if inflation is zero, mathematically, it means that the actual debt burden increases. This is especially dangerous if there is already a large accumulated level of debt in the economy. Furthermore, with zero inflation, the dollar is “cheapening,” which will eventually increase the real value of national currencies. However, it should be recognized that most multinational companies are oriented towards the U.S. dollars, and hence the growth of national currencies is unlikely to be positive news for them.
The reduction of the free money supply, which is equivalent to removing 6% of cash from the turnover, produced by the Federal Reserve, entails a number of circumstances both in the short and long term. In particular, a sufficient 3 percent unemployment rate creates a liquidity deficit in which consumers lack the money to pay for goods and services of the U.S. economy (Chappelow, 2019). This, in turn, reduces consumer spending and overall aggregate demand. Given the supply and demand nexus, low demand stimulates a reduction in production capacity. In order for citizens to survive, stores and manufacturers are likely to have to lower prices, driven by lower inflation, as the Phillips curve postulates (Barnier, 2020). A reduction in the money supply also responds to an upsurge in the real interest rate’s value, which reduces investment interest and the attractiveness of the Central Bank.
In the long run, the reduction in the money supply will result in higher unemployment, currency appreciation, and, if we look at a very distant period, a smooth recovery of the economy with the current level of GDP. The fall in wages, which means a growth of the unemployment rate, is stimulated by the mismatch between the total and nominal output. Moreover, after a regression in the money supply, the exchange rate upsurges in the long run. This is because the decline in national income reduces domestic demand for imported products, forcing local consumers to show less demand for foreign currency to buy imported goods. In addition, the domestic real interest rate makes domestic assets more attractive to foreign investors, increasing their demand for national currency. In the long run, the 6% reduction has the potential to reduce price levels, but over time the economy is expected to reach a balance.
Reference
Akerlof, G. A., Perry, G. A., & Dickens, W. T. (n.d.). Low inflation or no Inflation: Should the Does the Federal Reserve pursue complete price stability? Brookings. Web.
Barnier, B. (2020). Phillips curve. Investopedia.
Chappelow, J. (2019). Liquidity crisis. Investopedia.
Yellen, J. (2017). Nobody seems to know why there’s no US inflation. Financial Times. Web.