The Problem of Inflation

that they thought inflation was "public enemy number one"; one victim of the public's fear of inflation was President Jimmy Carter, who lost his reelection bid to Ronald Reagan in 1980 in part because of his perceived inability to control infla­tion.

The Costs of Inflation

The costs of inflation depend primarily on whether consumers, investors, work­ers, and firms are able to predict the inflation before it occurs. To illustrate this point, we discuss two extreme cases: an inflation that everyone is able to predict and an inflation that comes as a complete surprise.

Perfectly Anticipated Inflation. Let's first consider the case of an inflation that is perfectly anticipated by the public. Imagine, for example, that everyone knew that the inflation rate would be 4% per year. To keep things simple, assume no change in relative prices so that the prices of all individual goods and services also are rising at the rate of 4% per year.

Why then does a fully anticipated inflation impose any costs? The prices you pay for groceries, movie tickets, and other goods would increase by 4% per year but so would your nominal wage or the nominal value of the goods or services you produce. Because your nominal income is rising along with prices, your pur­chasing power isn't hurt by the perfectly anticipated inflation.^[230]

What about the money that you hold in your savings account? Although infla­tion reduces the purchasing power of money, perfectly anticipated inflation wouldn't hurt the value of your savings account. The reason is that the nominal interest rate would adjust to offset the drop in the purchasing power of money. For instance, with a zero inflation rate and a nominal interest rate on savings deposits of 3%, the real interest rate also is 3% per year.

The suggestion that perfectly anticipated inflation imposes no economic costs isn't quite correct: Inflation erodes the value of currency, which leads people to keep less currency on hand—for example, by going to the bank or the automatic teller machine to make withdrawals every week instead of twice a month. Similarly, inflation may induce firms to reduce their cash holdings by introducing computerized cash management systems or adding staff to the accounting depart­ment. The costs in time and effort incurred by people and firms who are trying to minimize their holdings of cash are called shoe leather costs. For modest inflation rates, shoe leather costs are small but not completely trivial. For example, the shoe leather costs of a 10% perfectly anticipated inflation have been estimated to be about 0.3% of GDP, which is more than $50 billion per year in the United States.^[232]

A second cost of perfectly anticipated inflation arises from menu costs, or the costs of changing nominal prices. When there is inflation and prices are continu­ally rising, sellers of goods and services must use resources to change nominal prices. For instance, mail-order firms have to print and mail catalogues frequently to report the increases in prices. Although some firms face substantial menu costs, for the economy as a whole these costs probably are small. Furthermore, techno­logical progress, such as the introduction of electronic scanners in supermarkets, reduces the cost of changing prices.

Unanticipated Inflation.

What is the effect of 6% inflation if (1) you expected 4% inflation and (2) your savings account pays 7% interest? When inflation is 6% per year instead of 4% per year, the actual real interest rate on your savings account is only 1% per year (the nominal interest rate of 7% minus the inflation rate of 6%) instead of the 3% per year that you expected. By earning a lower actual real interest rate, you lose as a result of the unanticipated inflation. However, your loss is the bank's gain because the bank pays a lower real interest rate than it expected. Note that the roles would have been reversed if the actual inflation rate had been lower than expected; in that case the real interest rate that you earn, and that the bank has to pay, would be higher than anticipated.

Similarly, suppose that your nominal salary is set in advance. If inflation is higher than expected, the real value of your salary is less than you expected, and your loss is your employer 's gain. If inflation is lower than expected, however, you benefit and your employer loses.

These examples show that a primary effect of unanticipated inflation is to trans­fer wealth from one person or firm to another. People who lend or save at fixed interest rates (creditors) and those with incomes set in nominal terms are hurt by unanticipated inflation, whereas people who borrow at fixed interest rates (debtors) or who must make fixed nominal payments are helped by unanticipated inflation.

For the economy as a whole, a transfer of wealth from one group to another isn't a net loss of resources and hence doesn't represent a true cost. However, from the viewpoints of individual people and firms in the economy, the risk of gaining or losing wealth as a result of unanticipated inflation is unwelcome.

In Touch with Data and Research

Indexed Contracts

In principle, much of the risk of gains and losses associated with unanticipated inflation can be eliminated by using contracts in which payments are indexed to inflation. If a bank wanted to offer a guaranteed 3% real interest rate on savings accounts, for instance, it could index the nominal interest rate to the rate of infla­tion by offering to pay a nominal interest rate equal to 3% plus whatever the rate of inflation turns out to be. Then if the actual inflation rate is 6%, the bank would end up paying a nominal interest rate of 9%—giving the depositor the promised 3% real interest rate. Similarly, other financial contracts, such as loans, mortgages, and bonds, can be indexed to protect the real rate of return against unanticipated inflation. Wage payments set by labor contracts can also be indexed to protect workers and employers against unanticipated inflation. (We discussed the macro­economic effects of wage indexation in Appendix 11.A.)

How widespread is indexing? Most financial contracts in the United States are not indexed to the rate of inflation, although payments on some long-term financial contracts (adjustable-rate mortgages, for example) are indexed to nominal interest rates such as the prime rate charged by banks or the Treasury bill inter­est rate. Because nominal interest rates move roughly in step with inflation, these long-term financial contracts are to some extent indexed to inflation.

In countries that have experienced high and unpredictable inflation rates, indexed contracts are common. A case in point is Israel, which had a CPI inflation rate of 445% per year in 1984. At that time, more than 80% of liquid financial assets in Israel were indexed: For example, long-term government bonds were indexed to the CPI, and banks offered short-term deposits whose purchasing power was tied to that of the U.S. dollar. However, the fraction of financial assets that were indexed decreased after the Israeli hyperinflation ended in the second half of 1985, and continued to decrease as Israeli inflation fell to single digits.^[233]

²⁴See Stanley Fischer, “Israeli Inflation and Indexation," in J. Williamson, ed., Inflation and Indexation: Argentina, Brazil, and Israel, Institute for International Economics, 1985, reprinted in Stanley Fischer, Indexing, Inflation, and Economic Policy, Cambridge, MA: MIT Press, 1986; and Zalman F. Shiffer, “Adjusting to High Inflation: The Israeli Experience," Federal Reserve Bank of St. Louis Review, May 1986, pp. 18-29. farmer make good economic decisions unless they also know the price of corn. When inflation is unanticipated, particularly if it is erratic, people may confuse changes in prices arising from changes in the general price level with changes in prices arising from shifts in the supply or demand for individual goods. Because the signals provided by prices may be distorted by unanticipated inflation, the market economy works less efficiently.

The Costs of Hyperinflation. Hyperinflation occurs when the inflation rate is extremely high for a sustained period of time.^[234] For example, during a 12-month period beginning in August 1945, the average rate of inflation in Hungary was 19,800% per month.^[235] In the more recent hyperinflation in Zimbabwe, the annual rate of inflation was 1017% in 2006, 10,453% in 2007, and soared to 55.6 billion per­cent in 2008, before dropping to 6.5% in 2009.^[236] The costs of inflation during these hyperinflations were much greater than the costs associated with moderate infla­tion. For example, when prices are increasing at such mind-boggling rates, the incentives to minimize holdings of currency are powerful and the resulting shoe leather costs are enormous. In severe hyperinflations, workers are paid much more frequently—perhaps even more than once a day—and they rush out to spend their money (or to convert their money into some other form, such as a foreign cur­rency) before prices rise even further. The time and energy devoted to getting rid of currency as fast as possible wastes resources and disrupts production.

One early casualty of hyperinflations is the government's ability to collect taxes. In a hyperinflation, taxpayers have an incentive to delay paying their taxes as long as possible. Because tax bills usually are set in nominal terms, the longer the tax­payer delays, the less the real value of that obligation is. The real value of taxes collected by the government falls sharply during hyperinflations, with destructive effects on the government's finances and its ability to provide public services.

Finally, the disruptive effect of inflation on market efficiency that we dis­cussed earlier becomes most severe in the case of a hyperinflation. If prices change so often that they cease to be reliable indicators of the supply and demand for dif­ferent goods and services, the invisible hand of the free market can't allocate resources efficiently.

Can Inflation Be Too Low? Our discussion of the costs of inflation has focused on the case of inflation that is too high. What about the case in which inflation is very low, or prices are actually falling, a situation known as deflation? Should cen­tral banks be concerned?

In fact, very low inflation, and especially deflation, can be harmful for the econ­omy. For example, just as unanticipated inflation helps those who borrow at fixed interest rates, unexpected deflation hurts borrowers. Indeed, sufficiently severe unexpected deflation—as occurred in the United States during the 1930s, when prices for a time fell by about 10% per year—can lead to widespread bankruptcies and financial distress, as borrowers' nominal incomes fall relative to their contrac­tual debt payments.

Like anticipated inflation, anticipated deflation also has costs. For example, if nominal wages are sticky (and, in particular, if they do not easily adjust down­ward), deflation will raise real wages over time, by lowering the prices of the things workers buy. That's good for those who remain employed, but it can also create more unemployment if the real wage rises above the level implied by the balancing of supply and demand in the labor market. Like anticipated inflation, anticipated deflation can also reduce the efficiency of markets because people find it more dif­ficult to determine the relative prices of the goods and services they buy and sell.

An important cost of anticipated deflation arises from the fact that nominal interest rates generally cannot fall below zero. Suppose, for example, that prices are falling at 2% per year (π = — 2% per year). Then the lowest possible value for the real interest rate that the central bank can achieve is 2%, equal to a zero nominal interest rate less the inflation rate of minus 2% per year; in equation form, r = i — π = 0 — (-2) = 2% per year. If the real interest rate required to restore full employment is less than 2% per year, but a 2% per year deflation is ongoing, the central bank will not be able to cut the real interest rate by as much as the economy needs, even by cutting the nominal interest rate all the way to zero. (In contrast, if inflation were positive 2% per year, by cutting the nominal interest rate to zero the central bank could achieve a real interest rate of minus 2% per year, since r = i — π = 0 — 2 = — 2% per year.) In Chapter 14, we discuss issues related to the zero lower bound on the nominal interest rate (and point out a few cases in which the nominal interest rate has been slightly negative in some countries).

If both high inflation and very low inflation have costs, what inflation rate should the central bank aim for? Today, many central banks around the world aim for an inflation rate of about 2% per year, which is a relatively low rate (thereby minimizing the costs of inflation that is too high) but which also reduces the risk that an unexpected shock will drive the economy into deflation. In addition, some evidence suggests that, for technical reasons, official measures of inflation in the United States somewhat overstate the true inflation rate; accordingly, if the Fed targets 2% inflation, it is actually targeting a true inflation rate that is somewhat lower, as we discussed in Chapter 2, "In Touch with Data and Research: Does CPI Inflation Overstate Increases in the Cost of Living?"

12.4