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Is zero inflation a good thing?
Inflation is not a good thing because it slows down economic growth.
For example, when inflation is high, things cost more and people spend less. They also do less long-term planning that involves spending money, such as building houses and investing. Businesses are affected in the same ways. When inflation is high, it tends to fluctuate quite a bit. This uncertainty makes people wary of spending money for fear that inflation will increase even more and they won't be able to pay their bills.
High inflation also adds additional costs to long-term interest rates. These costs are to offset the risk associated with inflation. The additional costs make borrowing money less attractive. When people don't buy things (when demand is down), then the supply of goods gets too high, production has to decrease, and unemployment increases -- in other words, recession hits.
When prices are stable (when inflation is low), consumers make more purchases, investments, etc., production output is maintained and employment remains high.
In theory, if inflation NEVER happened, then people would have more money to spend, when people have more money to spend, prices tend to go up. So to keep inflation in check, the Federal Reserve bank increases interest rates in order to keep too much money from going into the economy.
Fed Tasks: Monetary Policy Monetary policy refers to the actions the Fed takes to influence financial conditions in order to achieve its goals. The Fed's primary control is in the raising and lowering of short-term interest rates. In doing this, the Fed can indirectly influence demand, which then influences the economy. For example, if interest rates are lowered, borrowing money to make purchases becomes less expensive, and people are more motivated to spend money because they can get a better deal on the loan. Spending money, in turn, stimulates economic growth, which is what the Fed is trying to do in that instance. If there is too much money in the economy, however, people spend more money and demand increases at a faster rate than supply can match.
Prices rise too quickly because of the shortage of products, and inflation results. If there is too little money in the economy, people don't have excess spending money, and there is little economic growth.
The Fed watches economic indicators closely to determine in which the direction the economy is going. By forecasting increases in inflation or slow-downs in the economy, the Fed knows whether to increase or decrease the supply of money.
Influencing inflation takes a long time and has to be looked at as a long-term goal. Influencing employment and output, however, can be done more quickly and therefore is a short-term goal. Finding the balance between the two is key. The lags in the effects that monetary policy has on the economy are significant. This is why the Fed has to make forecasts of inflation prior to it actually happening -- one, two or even three years in advance. If the Fed waited until inflation were apparent, then it would be extremely difficult to catch up and get it back under control.
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