Why is inflation desirable?

Inflation is desirable when it is low and stable.

The easiest way to explain why is by outlining the consequences should inflation be either too high or too low;

1. If inflation is too high it often becomes very volatile and therefore differs widely from expectation. Risk averse people will want to protect themselves from this uncertainty and therefore may avoid financial planning, such as drawing up contracts.

2. If inflation is too low there is a risk of deflation (where general price levels fall in an economy). If inflation is at 0 or negative then people may decide to put off purchases, knowing that prices will fall and goods and services will become cheaper in the future. This however, leads to a vicious cycle, as the cost of production does not necessarily fall in line with prices. Therefore, facing lack of demand from consumers, producers may have to lay off workers or pay them less in order to stay in business. This in turn means demand falls further as fewer workers can afford the goods and services the producers are selling, and the cycle starts again.

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