Which do you think would be more harmful to the economy: an inflation rate that averages 5 percent a year and has a high standard deviation or an inflation rate of 7 percent that has a standard deviation close to zero?
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Without question, the higher but more stable inflation rate would be less harmful to an economy. In most cases, it is unpredictability, rather than inflation per se, that causes harm to an economy.
One of the main reasons that inflation is bad is because it can be unpredictable. When it is unpredictable, people cannot prepare for it. If, however, inflation is predictable, people can prepare for it and the harm from a rate in the range of 7% would not be very severe.
If everyone knows the inflation rate will be right around 7%, they can plan for it. Banks can set interest rates to get them a return over and above inflation. Firms can know how much they will need to increase their workers’ pay. By contrast, if the inflation rate is sometimes 2% and sometimes 8%, it is much harder to plan. If a bank plans for a 2% inflation rate and sets its interest rates at, say 5%, it actually loses money on loans that it makes if the actual inflation rate ends up at 8%. The bank will not, in that case, know what interest rate to set and may be less willing to lend.
Thus, it is much better to have a somewhat higher inflation rate as long as it is stable.
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