Dr. Econ, how does inflation affect economies?
You asked a very interesting and important question for
I discussed the definition of inflation. Also in that response
I emphasized that there are as many measures of inflation
as there are measures of overall price levels. Three popular
measures of overall consumer prices are the consumer price
index (CPI) published by the U.S. Bureau
of Labor Statistics, the personal
consumption expenditure (PCE) deflator published by the U.S.
Bureau of Economic Analysis,
and GDP deflator (published by the Bureau of Economic Analysis).
Figure 1 shows that these inflation series
(quarterly; year-over-year percent change; seasonally adjusted)
tend to follow similar paths.
Finally, note that economists often focus on core inflation
(which excludes volatile energy and food prices) rather than
overall inflation. To read more about core inflation, please
refer to my October
When trying to understand the debate about inflation or
interpret an inflation number reported in the press, it is
important to be clear on which measure of inflation is under
consideration to avoid confusion. That said, one thing about
inflation that is clear is how important it is to monetary
Importance of Price Stability
Central banks around the world view stable and low inflation
as a very important goal. Below are some concrete examples
(italics added for emphasis):
Reserve System: “Monetary
policy has two basic goals: to promote "maximum" sustainable
output and employment and to promote ‘stable’ prices.
These goals are prescribed in a 1977 amendment to the Federal
NOTE: On January 25, 2012, the Federal Open Market Committee issued a
"Statement of Longer-Term Goals and Policy Strategy." One of important announced in the statement was a 2 percent numerical inflation target for the overall personal consumption expenditures price index. Key points from the statement are:
- A commitment to the Fed's "statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates."
- A numerical longer-run goal for the personal consumption expenditure price index of 2 percent.
- An estimate of the longer-run normal rate of unemployment in the 5.2 to 6.0 percent range.
of Japan: “The
Bank of Japan, as the central bank of Japan, decides and
implements monetary policy with the aim of maintaining
Central Bank: “To
maintain price stability is the primary objective of the
Eurosystem and of the single monetary policy for which it
is responsible. This is laid down in the Treaty establishing
the European Community, Article 105 (1).”
Bank sets interest rates to keep inflation low, issues banknotes
and works to maintain a stable financial system.”
Bank of Canada: “The
goal of Canadian monetary policy is to contribute to rising
living standards for all Canadians through low and stable
of Chile: “The
main purpose of the Central Bank of Chile’s monetary
policy is to keep inflation low and stable, defined as a
range of 2% to 4% per annum, centered on 3%.”
Policymakers and economists are not the only groups concerned
with inflation and its consequences. The general public has
a great distaste for inflation too. It has been noted that
news about inflation can damage approval ratings of presidents
and affect outcomes of elections. A look at public opinion
polls reveals that inflation at times can be viewed as the
most important national problem (Shiller 1996).
Costs of Inflation
Although I have given you all this evidence that many groups
view inflation as a serious problem, I have not begun to
discuss why. It is interesting to note that while both economists
and non-economists tend to dislike inflation, they dislike
it for different reasons. Non-economists would most likely
argue that inflation erodes their purchasing power. In an
international survey conducted in the 1990s by a prominent
Yale economist Robert Shiller, other concerns with inflation
expressed by non-economists were centered around issues of
exploitation, political instability, loss of morale, and
damage to national prestige (Shiller 1996).
The costs of inflation cited by economists tend to be different
and fall into two categories: the costs of expected inflation
and the costs of unexpected inflation. The remainder of this
discussion will focus on these costs. This does not mean
that the costs cited by non-economists are not important.
However, there is quite enough to say about the costs of
inflation without branching outside of economics!
Costs of Expected inflation:
- Shoe-leather costs. These costs reflect
the inconvenience of a reduction in money holding that
arises during periods
of high inflation when individuals tend to make more
frequent but smaller cash withdrawals. The name “shoe-leather” is
metaphoric – walking to the bank wears out one’s
shoes, but worn-out shoes is hardly the only inconvenience
of going to the bank more often. Example
further intuition for this cost of inflation.
- Menu costs. These costs arise due to
firms changing and posting their prices with higher frequency
high inflation. The name “menu” costs refers
to restaurants having to change prices of dishes (and,
therefore, print new menus) more often during high-inflation
Restaurants, of course, are not the only businesses that
incur menu costs. While one might think of menu costs
as costs that follow the decision about what the new
should be (such as reprinting catalogs, updating computer
reprinting price tags, etc.), it is useful to keep in
mind the cost of the very decision of what the new price
to be (such as gathering relevant information and processing
- Increase in relative price volatility. These costs
arise because firms facing menu costs are not likely
prices frequently. As a result, relative price volatility
increases. This, in turn, leads to inefficiencies in
resource allocation. For more details, please see Example
- Tax distortions. These costs arise because
many tax laws do not take inflation into account. That
one’s nominal rather than real income. Inflation
can result in an arbitrary change in a person’s
tax liability. For more details, please see Example
Costs of Unexpected Inflation
- Arbitrary redistribution of wealth from lenders
to borrowers. When inflation turns out to be different from
some groups can be made better off, while others can be
made worse off. For instance, when inflation turns out
to be higher
than expected, lenders can realize losses, while borrowers
can gain. For more details, please see Example
- Costs to individuals on fixed nominal contracts. Many
long-term contracts build in an adjustment for inflation.
People whose contract payments are fixed will suffer
a loss in real terms (that is, in terms of purchasing power)
inflation turns out higher than they expected. For example,
if pension payments are fixed for many periods and inflation
ends up being higher than expected, then real pension
payments end up being lower than expected.
How Large Are These Costs?
It is natural to wonder which of the cited costs of inflation
is the largest or most important. The answer to this question
truly depends on the time period considered, the country
under consideration, and the severity of inflation or deflation
(for instance, it matters whether it is moderate, high, or
Though it is hard to quantify the costs of price volatility,
it is a critical issue, especially for a central bank. What
may surprise some people is that, although inflation is costly,
policymakers generally do not wish for zero inflation. This
is because reducing inflation from some low positive rate
to zero might come at the expense of higher unemployment
(and lower output). Thus, the costs of going from low to
zero inflation are thought to exceed the benefits. This is
further complicated by the difficulty of measuring inflation
precisely enough to be certain exactly how close you are
to zero inflation. Of course, that is why economists keep
a close eye on several measures of inflation!
Bernanke, Ben. 2002. “Deflation:
Making Sure ‘It’ Doesn't
Happen Here” Remarks Before the National Economists
Club, Washington, DC.
English, William. 1996. “Inflation and Financial
Sector Size.” Board of Governors of the Federal Reserve
System, Finance and Economics Discussion Series. 96-1.
Fuhrer, Jeffrey, and Geoffrey M.B. Tootell. “Issues
in economics: what is the cost of deflation?” 2004.
Federal Reserve Bank of Boston. Regional Review. Q 4 2003
/ Q1 2004, 2004 pp. 2-5.
Mankiw, Gregory. 2003. Macroeconomics, 5th edition. New
York, NY: Worth Publishers.
Pakko, Michael. 1998. “Shoe-Leather Costs of Inflation
and Policy Credibility.” The Federal Reserve Bank
of St. Louis Review. November/December 1998.
Shiller, Robert. 1996. “Why Do People Dislike Inflation?” NBER
Working Paper No. 5539.
Zbarski, Mark J. Mark Ritson, Daniel Levy, Shantanu Dutta,
and Mark Bergen. 2004. ”Managerial and Customer Costs
of Price Adjustment: Direct Evidence from Industrial Markets.” The
Review of Economics and Statistics, vol. 86(2), pp.514–533.
Example 1 – Shoe-leather costs of inflation
The intuition behind the shoe-leather cost of inflation
is that during times of high inflation, households make
smaller cash withdrawals with higher frequency. That
is, instead of withdrawing $200 once a week, they might
withdraw $50 four times a week, thereby, “protecting” their
assets from inflation by keeping them in an interest-bearing
Example 2 – Increase in relative price volatility
Suppose firm X produces one good and changes its price
once a year (menu costs prevent this firm from changing
its prices more often). In the case of no inflation in
the economy (that is, the case when prices of other goods
and services do not change), then the relative price
of firm X’s good is constant throughout the year.
Suppose, however, that inflation is 0.5% per month. In
this case, prices of other goods and services increase
by 0.5% every month, while the price of the good produced
by firm X remains constant. Thus, the good produced by
this firm becomes increasingly cheaper relative to other
goods. In this scenario, sales of firm X might be relatively
low at the beginning of the year (when the price of its
good is relatively high) and increase towards the end
of the year (as the relative price of its good falls).
Economists believe that inefficiencies in resource allocation
will result from this scenario.
Example 3 – Tax distortions
Suppose that you bought some asset for $100 in period 1
and sold it for $110 in period 2. You made a profit of
$10 (10%). You have a nominal gain of $10, but whether
you made a gain in real terms or not depends on inflation.
If there is no inflation between periods 1 and 2, then
your real gain is 10%. You can buy 10% more goods and
with $110 in period 2 than you could with $100
in period 1. Now suppose that inflation between periods
1 and 2 was 10%. In this case, you can buy as many goods
and services with $110 in period 2 as you could with
$100 in period 1—you made no real gains. Yet,
regardless of whether you made any real gains or not,
you may still have to pay taxes on the nominal gain.
Example 4 – Redistribution of wealth from
lenders to borrowers
Suppose that you lend someone $100 at an interest rate
of 10% for one year. Suppose also that both you and the
person you are lending to expect inflation to be 3% per
year, but that in reality inflation ends up being 10% per
year. Regardless of the inflation rate, your nominal gain
and the borrower’s nominal cost is $10. However,
because of unexpectedly high inflation, you received less
in real terms than anticipated (because prices of goods
and services rose faster than you expected, you can buy
less with your $110 than you could otherwise). On the other
hand, the borrower paid you less than expected in real
terms (thus giving up less in terms of goods and services
than they thought they would at a time of entering into
this agreement with you). Thus, you (the lender) suffered
an unexpected real loss, while the borrower made an unexpected
1 For further discussion of shoe-leather costs, please
see English (1996) and Pakko (1998).
2 For further discussion of menu costs see Zbarski et al. (2004).
3 For a discussion of nominal vs. real variables, see Mankiw (2003).