The Costs of Inflation:

Inflation does have costs however they are subtle. For the most part the costs of reasonable inflation appear to be relatively small, smaller than one would estimate given the strength of today's political consensus that price stability is a very desirable goal.

The Costs of Moderate Expected Inflation:

The costs of expected inflation are particularly small. Expected inflation increases the nominal interest rate which you will recall is equivalent to the real interest rate plus the rate of inflation. Ever since the nominal interest rate is the opportunity cost of holding funds balances, when the ostensible interest rate is high you devote more time and energy to managing your cash balances. From the point of view of the economy as a whole, this extra time as well as energy is just wasted. Nothing helpful is produced and valuable resources that could be used to add to output or simply spent enjoying yourself are used up.

Expected inflation wastes time as well as energy in other ways as well. Firms find that they should spend resources changing their prices not because of any change in their business but merely because of inflation. Households discover that it is harder to figure out what is a good and what is a bad purchase as inflation pushes prices away from what they had perceived normal prices to be. The gravest costs of expected inflation surely come from the fact that our tax laws aren’t designed to deal well with inflation. Lots of productive activities are punished and lots of unproductive ones rewarded simply because of the interaction of inflation with the tax system. The fact that debt interest is treated as a cost signifies that in times of high inflation it is artificially cheap to finance businesses by issuing bonds are borrowing at the bank and consequently businesses adopt debt-heavy capital structures that may make the economy more vulnerable to financial crises and certainly raise the amount of resources wasted paying bankruptcy lawyers as businesses with lots of debt tend to go bankrupt relatively easily.

However when the rate of inflation is low—perhaps when inflation less than ten percent per year, perhaps when inflation is less than five percent per year, and surely when inflation is less than two percent per year--these costs are too little to worry about because they are counterbalanced by benefits. Presume the central bank wishes to push the real interest rate below zero in some economic crisis? It can’t do so unless there is a few inflation in the economy, for the reason that nominal interest rates cannot be less than zero and the real interest rate is the difference among the nominal interest rate and the inflation rate. Several economists and psychologists have speculated that worker morale is greatly harmed if worker wages are obviously and unambiguously cut. A little amount of inflation may then grease the wheels of the labor market, permitting for wage adjustment without the damaging effect on morale of explicit wage cuts.

The Costs of Moderate Unexpected Inflation:

Unexpected inflation does have important and worrisome costs for unexpected inflation redistributes wealth from creditors to debtors. Creditors receive much fewer purchasing power than they had anticipated if a loan drops due during a time of significant inflation. Debtors find the payments they should make much less burdensome if they borrow over a period of significant inflation. The process works in overturn as well: if inflation is fewer than had been expected, creditors receive a windfall as well as debtors go bankrupt. Most people are averse to risk. We purchase fire insurance, finally. People who are reluctant to risk dislike uncertainty and unpredictability--and unexpected inflation certainly creates uncertainty and unpredictability.

Yet possibly these economic costs of moderate unexpected inflation are relatively low. Why don't debtors as well as creditors want to insure themselves against inflation risk by indexing their contracts as well as using some alternative, steadier unit of account? In economies with high as well as variable inflation, we do observer such indexation. The fact that we don’t in countries with moderate and low inflation suggests that the costs of inflation to individual debtors and creditors (though possibly not to society as a whole) must be relatively low.

Alternatively there is a powerful political argument that the costs of moderate inflation are high. Voters don’t like moderate inflation. The 1970s saw government subsequent to government in the industrialized world voted out of office. Polls showed that voters interpreted increasing rates of inflation as signs that political parties in power were incompetent at managing the economy. Ever since the end of the 1970s no major political party in the industrialized world has dared run on a platform of less price stability and more inflation.

Hyperinflation and Its Costs:

We are able to see the costs of inflation mount to economy-destroying levels during episodes of so-called hyperinflation, when inflation increases to more than 20 percent per month.

Hyperinflations happen when governments attempt to obtain extra revenue by printing money, and overestimate how much they can rise. For a few governments printing money is a significant source of revenue. Most governments tax their citizens or else borrow from people who think that the government will pay them back. However if a government finds that it doesn’t have the administrative reach to increase its explicit tax take and that no one will lend to it, it can merely print money and use the bills hot off the press to purchase goods and services.

Where perform the resources--the power to buy goods and services--which the government acquires by printing money, come from? The reply is that a government that finances its spending by printing money is in reality financing its spending by levying a tax on holdings of cash. Presume I have $500 in cash in my pocket when the government suddenly announces it has printed up sufficient extra dollar bills to double the economy’s cash supply. With Y and V unaffected doubling the money supply doubles the price level. The $500 in my pocket will buy only as much subsequent to the government's money-printing spree as $250 would have bought before. It is as if the government imposes a special one-time 50% tax on cash holdings.

Figure: The Inflation Tax

Legend: The inflation tax is a means for the government to get command over goods and services just as a lot as is any other tax. Those who pay the price rises tax are those who hold assets that lose value in the event of inflation.

Where performed the $250 real dollars in my pocket go? The government has them- it at the present has 500 newly-printed dollars even if each of them is worth half a pre-inflation dollar in real terms. Obviously printing money can be easier than imposing a 50% explicit tax. To gather an explicit tax a government needs need a complete money-collecting, wealth-tracking and compliance-monitoring bureaucracy. To print money all the government requires is some paper, a printing press, some ink, and a working connection to the electric power grid.

Approximately everyone agrees that this inflation tax--also called seignior age for the reason that the right to coin money was initially a right reserved to certain feudal lords, certain seigneurs--is a bad policy. One of the first values of public finance is that taxes must be broad-based and lie relatively lightly on economic activity. The inflation tax is a profound tax on a narrow base of economic activity, the activity of holding money. Furthermore the inflation tax is a heavy tax on one small slice of money-holding: cash as well as deposits at the central bank.

Other mechanism of the money stock--your checking account say—isn’t a potential source of purchasing power for the government through the inflation tax. Presume that you deposited your money in your checking account and the bank then took that purchasing power as well as used it to buy an office building. If the price level twice you have lost half the real value of your checking account yes. However the gainer in real terms isn’t the government. The gainer in real terms is the bank that at the moment finds the value of the office building it owns to be twice as large relative to the value of the money it owes to its depositors isn’t only a bad tax however in its operation it disrupts the rest of the financial system as well.

Therefore the inflation tax is merely resorted to by a government that is falling apart and lacks the administrative capacity to elevate money in any other way. Even therefore such a government typically finds out afterwards that the costs of the inflation tax and hyperinflation outweigh the benefits. Ultimately prices rise so rapidly that the monetary system breaks down. People would rather deal with every other in barter terms than use a form of cash whose value is shrinking measurably every day. GDP starts to drop as the economy begins to lose the benefits of the division of labor. In the end the government discovers that its currency is next to worthless. It runs the printing presses faster as well as faster and yet finds that the money it prints buys less and less. At the end of the German hyperinflation of the 1920s one trillion marks were needed to buy what one mark had bought less than ten years prior to.

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