In earlier article we study the cost of inflation to reduce target rate of inflation to 0% now we will study benefits of inflation to reduce inflation rate.
The benefits of inflation are:
1.Seignorage- Money creation the source of inflation in which govt can finance its spending and its money creation is an alternative of borrowing from public or raising taxes .Government sell bonds to RBI and they create money ,thus revenue from money creation are called seigniorage allow the government to borrow less from the public or lower taxes.
2.The option of negative real interest rates-
Two economies with same real interest rate equal to 2% .In 1 economy RBI maintain the inflation 4% thus nominal interest rate will be 6%.In 2 economy RBI maintain 0% inflation thus nominal interest will be 2%.Suppose both economies hit by shock leads to given interest rate to decrease spending and output in short run .
In 1st economy ,RBI decreses the nominal interest rate 6% to 0% and in 2nd economy RBI decreases 2%to 0% with the assumption that expected inflation will not change immediately thus In 1st economy real interest rate will be -4% and in 2nd economy it is 0%.
Thus the economy with higher average inflation has more scope to use monetary policy to fight recession.
3.Money illusion revisited – suppose a country with inflation 4% leads to wages goes up by 1% in nominal thus real wage rate would be -3%.and when inflation is 0% ,wages go down by 3% in nominal thus real wage rate would be -3% .In both cases real wage rate is -3% fall in real wages.
Many people allow with 1st case for these downward real wage adjustment than when there is no inflation.
4.The optimal inflation rate- OECD countries says inflation (3%) is fine and those who want price stability 0% inflation.They argue that some of the cost of inflation could be avoided by issuing the indexed bonds and indexing the tax system.They argue inflation down from current rate to zero leads to increase in unemployment and transactions cost may well exceed the eventual benefits.
These benefits of inflation are considered by RBI while reducing inflation .