64 THE BiG DROP
inflation is, central banks can always tame it with more rate
increases.
The classic case is Paul Volcker in 1980 who raised inter-
est rates to twenty percent in order to crush inflation that had
reached thirteen percent. Central bankers feel that if the inflation
genie escapes from the bottle, they can always coax it back in.
Central bankers also believe that inflation can be good for
an economy. This is because of something called the Marginal
Propensity to Consume or MPC. The MPC is a measure of how
much an individual will spend out of an added dollar of income.
The idea is that if you give a poor person a dollar they will spend
all of it because they struggle to pay for food, housing and heath
care. If you give a rich person a dollar, they will spend very little
of it because their needs are already taken care of, so they are
more likely to save or invest that dollar. Based on this, poorer
people have a higher MPC.
Inflation can be understood as a wealth transfer from the
rich to the poor. For the rich person, his savings are worth
less, and his spending is about the same because he has a low
MPC. By contrast, the poor person has no savings and may
have debts that are reduced in real value during inflation. Poor
people may also get wage increases in inflation, which they
spend because of their higher MPC.
Therefore, inflation tends to increase total consumption be-
cause the wealth transfer from rich to poor increases the spend-
ing of the poor, but does not decrease spending by the rich who
still buy whatever they want. The result is higher total spending
or “aggregate demand” which helps the economy grow.
Deflation is not so benign and hurts the government in
many ways. It increases the real value of the national debt
making it harder to finance. Deficits continue to pile up even
in deflation, but GDP growth may slow down when measured
in nominal dollars. The result is that the debt-to-GDP ratio
can skyrocket in periods of deflation. Something like this has