I think we need a slightly more technical explanation of why inflation is good.

At the outset, I don’t believe that inflation is necessary for growth in the way described in the article. The late 19th century was marked by growth and deflation. It wasn’t the best outcome, but it demonstrated that growth does not cause inflation, or vice versa.

We need inflation because deflation encourages people to hoard their dollars, which reduces economic activity, which is bad for everyone. Inflation of 2% creates an incentive to keep the medium of exchange moving without making it necessary for people to renegotiate their deals too often. It is inefficient to spend more time discovering the nominal price of what you do than actually doing it.

Modest, predictable inflation has another rather elegant benefit. Lenders “underwrite” loans, meaning that they investigate the borrower’s creditworthiness before approving the loan. But once a loan is underwritten, the underwriting process ends (except in business loans, where ongoing covenants effectively re-underwrite loans continually). No one checks to see if you can still pay your mortgage or your car loan once you have been approved for it. As underwriting ages, it becomes less reliable, making the risk of default in the “out years” greater than the risk of default in the earlier years.

Inflation pushes back on this problem. The interest rate on loans includes an allowance for inflation. That portion of the periodic payment is really a return of principal to the lender in real terms. Even under an interest-only mortgage, a balloon payment in year 30 would be worth pennies on the dollar to the lender. As a result, the lender’s risk in real terms decreases each year as the loan ages.

At the same time, whatever level payment was approved on the basis of the original underwriting data, the borrower’s ability to pay that level amount grows each year as the real value of each successive payment declines. If the borrower’s income keeps up with inflation, the loan gets easier to carry, even if the borrower is otherwise no better off. This improvement in the borrower’s ability to pay despite no improvement in income reduces the lender’s risk of default.

Finally, inflation increases the value of collateral, most notably homes. So, as the underwriting data becomes less reliable, the collateral becomes more reliable. Again, the lender’s risk is reduced.

To recap, under modest, predictable inflation — the kind the Fed seeks to engender — lenders do best because economic activity is high, loans self-amortize with level payments, lenders become better able to service level payments, and collateral increases over time. All of these things reduce the risk lenders run, which reduces what they need to charge to make a profit. Thus, inflation increases the nominal rate of interest, but it lowers the real rate of interest, which further contributes to an upward spiral in activity.

That’s why the central bank likes inflation.