One of the most intractable problems confronting societies in transition from centralized to free market economies is that of inflation. It is, however, a challenge that such societies must meet if they are to enjoy the material benefits that a market economy can provide.
What exactly is inflation? It is an increase in the average price level of the goods and services produced and sold in an economy. Inflation typically occurs in a market economy for one of two reasons: either people increase their spending faster than producers are able to increase the supply of the goods and services; or there is a decrease in the supply of goods and services to consumers and/or producers, which drives up prices. Inflation has sometimes been described as an increasing amount of money chasing a shrinking number of goods.
Inflation hits economies in transition hard because price liberalization -- the removal of government control of prices -- is an essential step toward a market economy. The initial result of such price liberalization is predictable -- a wave of price increases for goods that were in chronic short supply. Why? Because the government held their prices artificially low, so demand perennially outstripped supply, or because of other economic distortions and inefficiencies created by government decision-makers. In addition, if people are holding large amounts of money at the time of this transition (since there was little of value to buy), the pressure of inflation can be even greater.
Nevertheless, the rewards of enduring the inevitable bout of inflation during this transitional period are substantial. Unfettered by government, the market mechanisms of supply and demand can begin to function. High prices signal strong demand, and the market, albeit slowly and haltingly at first, responds with increased production. Peoples' money may have lost value, but what money they have is now real, and consumers can buy the goods that are beginning to appear in stores. With supplies increasing, prices stabilize and queues begin to disappear as consumers realize that more and varied products will continue to be available for sale.
Entrepreneurs and investors respond to the new economic freedom by starting new businesses and competing to provide goods and services, thereby creating jobs, expanding supply, and causing prices to moderate further.
The key element in this transition is for the government to relinquish its role in setting prices and permit the market forces of supply and demand to establish prices for virtually all goods and services. When such a free market is established, inflation may persist, but it is a far more manageable and less threatening problem than in the early hard days of economic transition.
The devastation and pain caused by an explosive price rise in a transitional economy are obvious to all. However, are the typically lower rates of inflation in market economies a problem? Would people be better with no inflation and the same prices from 100 years ago and the same lower incomes that went with them? Not really. If Robert and Maria's income increases 10 times, but so do the prices of the things they buy, then they are no better off than before.
The reason people in market economies do care about inflation over shorter periods of time is that as prices rise, income and wealth are redistributed in arbitrary ways unrelated to the output or productivity of workers and firms. For example, say Robert and Maria have bought a house and borrowed the money to pay for it at a 10 percent interest rate. Then the rate of inflation rises from 5 percent to 15 percent. They will gain from these events, because the money they repay their loan with isn't worth as much as the money they borrowed to buy the house. In other words, it won't buy as many goods and services. That's good news for Robert and Maria, but bad news for whoever loaned them the money.
For the same reason, those who are on fixed pensions (or receiving other kinds of fixed payments established in long-term contracts) are hurt by inflation, while those who make the payments required in those contracts come out ahead. Savers and investors are hurt as well because inflation reduces the value of their money. By contrast, people who are able to pay off debts or other contractual obligations with inflated currency will usually gain unless the interest rate and other payments are allowed to vary with the level of inflation.
Nations require savings and a pool of loanable funds to invest in more capital resources -- houses, factories, and new technologies. By penalizing savers, therefore, inflation can reduce the growth and long-term prosperity of a nation. And in an even broader sense, inflation makes the business and economic world less predictable, which makes investments in other countries with little or no inflation more attractive. Is a company going to build a plant in a country with an unpredictable inflation rate ranging from 10 to 15 percent, or in a location with a past record of steady 2- to 5-percent inflation? The answer is the latter. In this sense, inflation makes many more losers than winners by disrupting the economic climate for every individual and business.
For all these reasons, government stabilization policies must balance the need to encourage economic growth against the requirement to keep inflation under control.