As we succeed, resource allocation moves closer to optimal, with attendant benefits for growth and living standards. The second broad reason why low inflation favors growth is that it contributes to financial stability. A low inflation economy is less likely to engender the sharp swings in asset prices and in expectations about such prices that have been so devastating to the financial system from time to time. In a sense, problems associated with the misjudgment of asset prices and their prospects are no different than the confusion about relative vs. general price changes I just described. Investors and creditors misjudge price signals and draw erroneous conclusions, financial resources are then misallocated, and disruptions occur.
Financial stability is vital to a prosperous economy in several ways.
Credit decisions, which determine the allocation of financial resources, are likely to be closer to optimal in a low inflation economy. Certainly, such events will cause dislocations, but a financial system which can absorb them without significant feedback to business activity helps to limit the extent and duration of the disruption. In these circumstances, growth will be affected less than it would be under conditions in which the financial sector magnifies and spreads the effects of the shock. Further, it is likely to be easier to identify the effects of shocks and the proper responses to them in a low-inflation environment. To be sure, all this talk about the benefits of low inflation would not matter much if the Federal Reserve, through monetary policy, cannot achieve and maintain low inflation.