Paul Krugman, lamenting our “dangerously low” inflation rate ,offered this explanation of why it’s a problem:
And, at this point, inflation — at barely above 1 percent by the Fed’s favored measure is dangerously low.
“Why is low inflation a problem? One answer is that it discourages borrowing and spending and encourages sitting on cash. Since our biggest economic problem is an overall lack of demand, falling inflation makes that problem worse.
Low inflation also makes it harder to pay down debt, worsening the private-sector debt troubles that are a main reason overall demand is too low.”
People, I don’t understand Krugman’s reasons at all
I thought that low inflation was a supposed to be a problem right now, because we are teetering on the brink of deflation with its associated fears of the decades long Japanese stagnation.
I thought low inflation was supposed to be a problem in the long run because it means the Fed would be more likely to hit the lower bound on its policy rate, complicating the implementation of a Taylor rule (or of monetary policy in general).
Some people think low inflation is a problem because it doesn’t erode real wages fast enough (phone call for Scott Sumner!).
But “low inflation discourages borrowing and spending?”
High real interest rates and risk aversion discourage borrowing. Hard to see an iron connection between them and low inflation.
Expectations of falling prices in the future and risk aversion discourage spending. Again, hard to link these to low inflation (except as I mentioned from the fear that low inflation will turn into deflation).
Now it’s certainly true for a given fixed interest rate, lower inflation will raise the real rate of interest. But that’s not how the economy works, even at our current “lower bound” situation. It’s the Fed’s policy rate that’s at the lower bound, not corporate bonds or long term government bonds, or mortgage rates. And furthermore, if inflation (or inflation expectations) were to rise, those key borrowing rates in the real economy would also be highly likely to rise, not stay constant. The Fed is unwilling or unable to peg long-term borrowing rates at zero, so higher inflation is not guaranteed to lower real borrowing rates at all.
However, I do have a “foolproof” way of creating inflation in the US. We can simply adopt the Venezuelan Bolivar or Argentine Peso as our national currency. BTW, this could work for the EU as well!