The cost of inflation
Posted July 8, 2008on:
Note: Other posts in this discussion are available under the tag “inflation debate“.
Hi again everyone. Apologises for the delay getting this out, I have been sick. I’m still feeling quite sick, so if you read anything you think is wrong be sure to comment on it – as it probably is.
The next step in this process is to ask, what are the costs of inflation?
Previously we defined inflation as:
when the price of all goods consistently increase for no “real” reason
Given this definition, we have to ask are there costs associated with a consistent increase in the general price level?
Wikipedia discusses the effects of inflation here (*). Interestingly, the authour of the wikipedia article seems to be pro low levels of inflation, something I’m not as fond of – but this will be an issue we will discuss after explaining the costs.
Now, starting with the assumption that higher mean rates of inflation also imply higher levels of volatility in the inflation rate wikipedia provides us with the following costs (Note, I have only taken the costs that are relevant for our context):
- Additional uncertainty about future price levels,
- Unintentional redistribution,
- Shoe leather costs,
- Menu costs,
- Distortions in the relative price,
- The current rate of inflation helps to determine future rates of inflation (such that all the above costs will also be repeated in the future partially as a result of current inflationary pressures).
Now the “redistribution” card is the one most often used by inflation fighters – however, I think it is a slightly overplayed card. Although it is costly to fix superannuation and tax brackets too inflation, such a policy provides one way of limiting the redistributive impact government policy may have in the face of inflation. Furthermore, private agents will have the incentive to index to inflation as long as the transaction costs of doing so are lower than the benefit in that environment.
As a result, there is some “upper ceiling” on the costs from inflation from this category. The cost is sheer irritation, and possibly some confusion, rather than the perverse costs economists often paint it out to be.
The next most popular costs are 3 and 4 (shoe leather costs and menu costs). However, these have been empirically measured and are quite low. As a result, you must be wondering why my rhetoric is always so anti-inflation.
You’re problem with inflation is?
Costs 1, 5, and 6 are the costs of inflation that truly subvert the nature of the economy.
Cost one is uncertainty. If high inflation is variable (or as we will discuss, high inflation messes up the efficiency of the price signal!) then uncertainty creeps into both the firms and households decision making process. As people are implicitly risk averse, uncertainty has a direct cost on peoples welfare. Furthermore, uncertainty limits firms incentive to invest.
Cost five is the one that drives me the most crazy – and the one that most other people don’t seem to care about! This cost states that the relative prices of goods mess up in an inflationary environment.
Now I care so much about “relative prices” because for an economist, having appropriate “relative prices” is the thing we really want from the market. When relative prices are set up efficiently, we know that the allocation of resources will be efficient.
This is a cost you don’t even see – people can’t tell that the allocation of resources could be more efficient, however, this does not stop this cost of inflation being very real.
Cost six follows on from the fact that current inflation rates influence future inflation rates. As inflation is largely the result of agents price setting behavoiur, and as many prices in the economy are sticky, if people expect a significant amount of inflation in the future it can become a self-fulfilling prophecy.
This implies that elevated levels of inflation now will keep inflation elevated in the future – implying that we will suffer from the first five costs to some degree in the future as well.
Wikipedia says that there are benefits from inflation as well – maybe these outweigh the costs!
The Wikipedia article also states that some people benefit from inflation. For example, people that have borrowed money would benefit from unexpected inflation, as the real value of their debt would fall. However, if the we truly have “persistent” increases in the price level, the nominal interest rate and agents behaviour would change to take this into account – as a result, I think these benefits are over-played.
The other benefit that is mentioned stems from the relative price issue I mentioned before. Specifically, the article correctly points out that prices are more “sticky” downward, and as a result if the relative price of these sticky price goods is falling, inflation may help take us too a better set of relative prices.
However, this argument doesn’t entirely convince me. If some prices are “sticky” downwards, then we would also require the other prices to be stick upwards to avoid the relative price adjustment wouldn’t we? If one good is relatively more expensive then it should be, wouldn’t that lead to substitution towards other goods which would lead to the relative price adjustment?
Furthermore, who says that goods that are sticky downwards are falling in relative value? The prime example of a good that has a “sticky downward price” is labour. With skills and labour productivity increasing, won’t the relative price of labour rise over time (I guess this depends on whether labour or capital productivity is increasing more :P ).
Another benefit they raise is that inflation allows bank’s to have “negative real interest rates” as a way of stabilising economic activity. This seems silly, given that people have a positive rate of time preference there is a positive interest rate that will still “stimulate” economic activity. Making real interest rates negative seems like overkill in a stabilisation sense.
As a result, I’m not convinced that these “benefits” from inflation is completely sensible.
So, we have determined that inflation has costs now, and costs in the future. This will be important for when we move on to discussing the “trade-off” involved in targeting inflation. So did I miss/mis-represent any costs?