Expectation, Inflation and Deflation

Econtalk.org had another good podcast today. One of the parts I liked best was a short statement about why the rate of inflation or deflation is not what matters, but rather unexpected changes in inflation/deflation. If only this more widely understood. In fact, I would argue that high rates of inflation are correlated with bad economies and not the cause of bad economies. It is more likely that the high inflation is caused by the government printing too much money.
“If everybody knew that prices were going to grow at 2% a year, everybody would factor that into interest rates. Value of the money changing hands a year from now goes up. Inflation would be irrelevant; deflation would also be irrelevant. People have this bizarre fear of deflation; unusual in our lifetime. If everybody understood that prices fell 2 or 3% a year, they would factor that into wage expectations, their borrowing and interest rates. Where you get real effects is when outcomes don’t mirror very closely your expectations. If I lend you $1000 and expect to get $1100 back, and prices are stable; if suddenly prices went up in a way that wasn’t anticipated at the time of the loan, those swings in reality versus expectations discourage economic activity.”

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