by Richard A. Posner
My last entry described a simple pattern in which the expansion of the money supply by the Federal Reserve and borrowing by the Treasury Department to finance soaring government debt--measures resulting from the depression--create a risk of inflation, which impels corrective action that can trigger a recession that would thus be an aftershock of the current depression. I need to be more precise about inflation, and in particular to avoid an implication that zero inflation is the summum bonum that the government should be striving to achieve.
In fact we may need inflation as one of the weapons to fight the depression, and this for two reasons. The first is to prevent deflation. Deflation, the opposite of inflation, refers to the situation in which the purchasing power of money increases because the ratio of money in circulation to the quantity of goods and services being sold decreases. Between 1930 and 1933, the dollar deflated at a rate of about 10 percent a year. This meant that on average if a product cost $1 in 1929, it would cost only 90 cents in 1930.
Deflation decreases economic activity by rewarding hoarding; in a deflation, money you put under your mattress will be worth more in a year just as if it were earning interest, but it will not contribute to consumption or investment because it is not being spent. To attract buyers in a deflation, sellers must reduce prices (otherwise the real as distinct from nominal price of their goods will rise), which increases deflation by reducing the ratio of money in circulation to goods. And deflation increases indebtedness in real terms, because people who contracted debts before the deflation began or was anticipated pay interest, and repay the principal of their debts, in dollars that are worth more.