The Costs of Inflation

I have never felt that the traditional treatments of the cost of inflation have the right emphasis. Here is what I would highlight for the costs of inflation:

Messing with the Price System. Prices are the central working parts to a remarkable and crucial coordination system for production and distribution of goods and services. The price system lets purchasers be aware of the costs and sellers be aware of the benefits of goods and services. Firms don’t all adjust their prices at the same time, so inflation tends to make older prices that have been set a while ago too low relative to newer prices that have been set recently. How long ago a price has been set has very little relationship to the costs and benefits of a good. So inflation is introducing a type of noise into the price system.

To see the losses from introducing noise into the price system, imagine that when firms set prices was kept the same, and how they decided on prices was kept the same, with one exception: after they had decided on prices, an evil genie came along and flipped a coin and raised or lowered the price by 2% depending on how the coin toss came out. This would cause all kinds of things to happen that serve no purpose.

There are also costs firms pay in order to keep inflation from messing with the price system even more than it does. Inflation makes firms feel the need to change prices more frequently. And in addition to the literal costs of changing physical price labels (sometimes called “menu costs”) more frequently, firms face the information processing costs of having to think about the macroeconomic rate of inflation rather than being able to simply focus on what is going on in their own market.

Messing with Our Minds. Inflation is confusing in many ways. This has costs. Where Greg Mankiw, in his intermediate macro textbook Macroeconomics, 10th edition, writes of inconvenience, I would go further to say inconvenience and confusion:

A fifth cost of inflation is the inconvenience of living in a world with a changing price level. Money is the yardstick with which we measure economic transactions. When there is inflation, that yardstick is changing in length. To continue the analogy, suppose that Congress passed a law specifying that a yard would equal 36 inches in 2019, 35 inches in 2020, 34 inches in 2021, and so on. The law would result in no ambiguity but would be highly inconvenient. When someone measured a distance in yards, it would be necessary to specify whether the measurement was in 2020 yards or 2021 yards; to compare distances measured in different years, one would need to make an “inflation” correction. Similarly, the dollar is a less useful measure when its value is always changing. The changing value of the dollar requires that we correct for inflation when comparing dollar figures from different times.

For example, a changing price level complicates personal financial planning. An important decision that all households face is how much of their income to consume today and how much to save for retirement. A dollar saved today and invested at a fixed nominal interest rate will yield a fixed dollar amount in the future. Yet the real value of that dollar amount —which will determine the retiree’s living standard—depends on the future price level. Deciding how much to save would be simpler if people could count on the price level in 30 years being similar to its level today.

The basic point is that inflation makes it harder to compare prices that one has seen at different times. But Greg writes as if everyone will, in the end, make all of inconvenient calculations to mentally adjust for inflation. What if they don’t? Then they will be prone to make mistakes in their economic decisions. As Greg notes, one of the most important decisions that needs an inflation adjustment is the decision of how much to save for retirement. Anyone who doesn’t correct for inflation will think their retirement saving plan will provide for a better standard of living in retirement than it actually will. This could lead to a big mistake that could mar someone’s life. They might avoid this mistake by going to a financial planner, but financial planning seldom comes for free: typically either (1) the financial planner takes a certain percentage of your assets every year (1% per year is a very large fraction of the entire rate of return one can hope to get in a year), (2) the financial planner steers you toward investments that make the planner money but are not so great for you, or (3) a financial planner refuses to work with you because it isn’t worth their time. (Regulations are moving against (2), pushing things toward (1) or (3).)

You could take classes so you can understand the different between a nominal and a real interest rate (that is, an inflation-adjusted interest rate) yourself, but that doesn’t come free either. If you attend ten classes each school year, take the annual tuition and what you could have been earning if you weren’t going to school, divide it by ten, subtract the value of the other things you learn in a macroeconomics class, then think of that as the price of learning to understanding real interest rates at the level you will understand by the end of that class.

One of the biggest failings of standard economic theory in 2019 is that it assumes that information processing comes for free. As I discuss in “Cognitive Economics,” this isn’t because economists believe that is true (although some economists can be dogmatic about the virtue of pretending it is true). It is because our theoretical tools are not well-suited to dealing with information processing costs. It will take a big advance in economic theory before we are able to deal with information processing costs in a satisfying way. In relation to the costs of inflation, our difficulty in modeling information processing costs means that the effect of inflation in raising those information processing costs is underestimated as a cost of inflation.

Messing with the Minds of Legislators. One subspecies of inflation messing with minds is that it messes with the minds of legislators. Legislators often don’t think about how inflation affects—or changes in inflation will affect—the laws that they write. This is a particularly big problem in the tax system. For example, almost all the countries in the world that tax interest income at all tax nominal interest income, rather than basing taxation on real interest income. And almost all the countries in the world that give a tax reduction to those who owe money for interest expense give a tax break based on nominal interest expense rather than on real interest expense. Capital gains taxation is almost always based on nominal capital gains. The tax treatment of interest and of capital gains is particularly consequential for the economy, so messing it up is a big deal.

Over time, certain pieces of the social safety net have come to be adjusted for price inflation or for the growth in nominal wages, but some are not. Occasionally, inflation may push laws in a direction that you like, but seldom was that the intent of the law! (For example, opponents of minimum wages might think it is a good thing that inflation erodes the minimum real wage. But that wasn’t the intent of the law.)

There are many areas where the costs of information processing mess up legislation that are not the result of ordinary inflation (see for example “VAT: Help the Poor and Strengthen the Economy by Changing the Way the US Collects Tax”), but reducing inflation a way of reducing information processing costs for legislators that is within the power of a central bank.

Messing with Debt Contracts. Some debt contracts—such as 30-year mortgages—last long enough that inflation is likely to change quite a bit over the life of the debt contract. When people write debt contracts in nominal terms, and inflation isn’t what they expected when they wrote those contracts, that change in inflation leads to a different outcome than intended when the debt contract was written.

Note that this is especially a cost of changes in inflation—and even more specifically of changes in inflation that were not anticipated. But there is a relationship between the level of inflation and changes in inflation. Because there is little temptation for deflation (having prices go down), when inflation is low there is not that much lower for it to go without the central bank making strenuous efforts to keep it from going too low. So when inflation is low it is easy to know in at least one direction what probably won’t happen. And when inflation is low, it is probably because a central bank thought low inflation was good, up to a point, which makes it even clearer what is likely to happen to inflation.

However, it is important to realize that not all of the correlation between low inflation and less variable inflation is low inflation causing less variable inflation. Much of this relationships between low inflation and less variable inflation is “Cousin Causality”: a good central bank will strive toward both low and more steady inflation, while a bad central bank will tend to have both higher and more variable inflation. It is good to have a good central bank.

Messing with the Opportunity Cost of Holding Money. Because it is easy to model, prominent in the traditional lists of the costs of inflation are “shoeleather costs”—the costs of going to the ATM more often to get cash when paper currency earns a rate of return much lower than the interest rate in a checking account. This cost of inflation only exists because of a tradition of having a zero rate of return for paper currency, something that may change in the future. (See “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.”) Strictly speaking, it is not a cost of inflation at all, but a cost of the spread between checking account interest rates and the paper currency interest rate. In addition to a possible nonzero paper currency interest rate in the future, that spread includes the real interest rate on checking accounts as well as the inflation component of the nominal interest rate on checking accounts. Nevertheless, higher inflation does tend to increase the spread between checking account interest rates and the paper currency interest rate.

To summarize, if inflation raises the spread between checking account interest rates and the paper currency interest rates it can lead to too little use of paper currency relative to checking accounts. Here I am focusing on people who use paper currency for legitimate transactions. As Ken Rogoff emphasizes in The Curse of Cash, much of the demand for paper currency is for tax evasion and other even worse illegal activities. Having a higher opportunity cost of holding paper currency to use in illegal activities might be a good thing.

When the spread between checking account interest rates and the paper currency interest rate rises, the spread between checking account interest rates and other interest rates—such as the Treasury bill rate—also tends to rise. This is a reflection of both people’s reluctance to go to the trouble of switching their money from one bank to another (including the reluctance to do long-distance banking with a bank they can’t see in person) and everything else that makes banks compete less fiercely with one another for deposits even when the interest rates the bank earns are far above the interest rates they are paying to depositors. As long as banks can get away with interest rates on deposit far below Treasury bill rates whenever there is a big gap between Treasury bill rates and the paper currency interest rate (which is typically zero), it can lead people to have inconveniently small amounts of money in their checking accounts as well as to have inconveniently small amounts of cash.

Note that cash, checking accounts and saving accounts all count as forms of money. So both of the effects mentioned above: on cash balances and on checking account/savings account balances are examples of a higher opportunity cost of holding money reducing money holding. In Divisia measures of monetary aggregates, the lower the interest rate someone is willing to put up with (compared to the Treasury bill rate), the more “moneyness” (=liquidity) a dollar of an asset is treated as having. By that measure, cash has more moneyness than funds in a checking account, and from that perspective, even though checking accounts are money, one can think of funds shifting from cash into checking accounts as a reduction in the amount of money.

More on Inflation Messing with Our Minds: Inflation Getting the Blame for Things It Doesn’t Do

Because inflation is confusing, it gets blamed for things it didn’t do and doesn’t do. Long-run forces that have very little to do with inflation determine the real wage and real rates of return (including the safe real interest rate). But to many people, inflation is the name for “My real wage doesn’t go up as fast as I think it should.” And to others, inflation is the name for “The real rate of return isn’t as high as I think it should be.” I, too, wish that real wages were growing faster and that real rates of return were higher. But inflation didn’t do it.

How can it be that inflation doesn’t reduce the growth rate of real wages or real rates of return? The answer is that standard theory predicts that a long-run, purely monetary change in inflation will raise nominal rates of return one for one and will raise nominal wages by as much as it raises prices. Higher inflation can often be a symptom of supply-side ills in the economy that both lower the growth rate of real wages and raise inflation (or both lower real rates of return and raise inflation). But in these cases, neither inflation nor real wage growth cause each other; rather they are correlated through “Cousin Causality.”

More on Inflation Messing with Our Minds: Inflation Making Real Wage Cuts Go Down More Easily

One partial exception to the idea that inflation doesn’t affect real wages is that when the forces of supply and demand point to a reduction in real wages for a given individual, that reduction in real wages may happen with less conflict when a constant nominal wage or a small increase in the nominal wage is accompanied by inflation than when there is a direct cut to nominal wages. In other words, confusing workers whose real wage is being cut may reduce conflict. This is typically counted by economists as a benefit of inflation, not a cost. But this benefit of inflation stems from inflation being confusing.

To describe the nature of the confusion from inflation, think of this. If my nominal wage is cut, there is usually a particular day when that happens. And if it were spread out over many days, that would probably make me feel worse. But when inflation erodes my real wage, the effect is not only spread out but my notification happens at the stores and online where I see higher prices, rather than being a notification from my employer.

Hyperinflation Messes with All of the Above, a Lot

The costs of hyperinflation are the costs above, multiplied many times over. You don’t want to go there.

How Negative Interest Rate Policy Can Allow Us to Reduce Inflation—and the Costs of Inflation

Even at moderate levels of inflation, the effects involving messing with minds can be a big deal. Fortunately, the progress of negative interest rate policy holds out the hope that we can take away the need for inflation in order to be able to have low real interest rates to stimulate the economy. On that, see “The Costs and Benefits of Repealing the Zero Lower Bound...and Then Lowering the Long-Run Inflation Target” and the other links flagged in “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide” (many cited in the appendix below). Being able to have low real interest rates to stimulate the economy when necessary is the primary benefit of having some inflation (with making real wage cuts go down more easily as the second substantial benefit to inflation). If we can have low real interest rates by having low nominal interest rates, we don’t need to have as much inflation to enable low real rates, so we can reduce inflation, reducing all of the costs of inflation mentioned above.

Appendix: Quotations from Other Posts on How Negative Interest Rate Policy Can Allow Us to Reduce Inflation

(I have made some formatting changes in the quotations, so they can be read more easily below.)

CHAIRMAN BERNANKE. Yeah. Okay. So historically, the argument for having inflation greater than zero–we define price stability as 2 percent inflation as do most central banks around the world. And one might ask, “Well, price stability should be zero inflation. Why do you choose 2 percent instead of zero?” And the answer to the question you’re raising which is that if you have zero inflation, you’re very close to the deflation zone and nominal interest rates will be so low that it would be very difficult to respond fully to recessions.

What the opponents of primacy for electronic money fail to realize is that making electronic money the economic yardstick is the key to eliminating inflation and finally having honest money.The European Central Bank, the Fed, and even the Bank of Japan increasingly talk about an inflation rate like 2% as their long-run target. Why have a 2% long-run target for inflation rather than zero—no inflation at all? Most things are better with inflation at zero than at 2%. The most important benefit of zero inflation is that anything but zero inflation is inherently confusing and deceptive for anyone but the handful of true masters at mentally correcting for inflation. Eliminating inflation is first and foremost a victory for understanding, and a victory for truth.

There are only two important things that economists talk about that are worse at zero inflation than at 2% inflation. One that has attracted some interest is that a little inflation makes it easier to cut the real buying power of workers who are performing badly. But by far the biggest reason major central banks set their long-run inflation targets at 2% is so that they have room to push interest rates at least 2% below the level of inflation. With electronic dollars or euros or yen as the units of account, there is no limit to how low short-term interest rates can go regardless of how low inflation is. So inflation at zero would be no barrier at all to effective monetary policy. It might be that we would still choose inflation a bit above zero to help make it easier to cut the real (inflation-adjusted) wage of poor performers at work, but I doubt it. So I predict that making electronic dollars the unit of account would pave the way for true price stability with long-run inflation at zero instead of 2%. The main benefit of making electronic currency the centerpiece of the price system would be that central banks would never again seem powerless in the face of a long slump. But even setting that gargantuan benefit aside, the benefits of true price stability alone would easily make up for any inconvenience from the abdication of paper currency in favor of the new rulers of the monetary realm: electronic dollars, euros and yen.

Yesterday’s paper currency is not only a barrier to speedy recovery from deep recessions—it is also a barrier to ending inflation. Many people don’t realize inflation in advanced economies such as the United States, the eurozone, and the United Kingdom is the result of conscious decisions of the Fed, the European Central Bank, and the Bank of England (with the Bank of Japan now trying to follow suit) to tolerate 2 percent inflation, in order to give monetary policy more room to maneuver. Here is the reasoning: Both households and businesses focus on interest rates in comparison with inflation when making spending decisions, so that higher inflation makes interest rates effectively lower. As economists say it, for a fixed nominal interest rate, higher inflation lowers the real interest rate. For example, if someone is paying 3 percent interest on a loan but inflation is 2 percent, then 2 percent is just making up for inflation, and only the remaining 1 percent actually gives the lender extra real value in terms of what the principal plus interest is worth. 

The key takeaway message for monetary policy is that because people look at how interest rates compare with inflation, an interest rate of zero that is 2 percent below inflation is much more stimulative than an interest rate of zero when inflation is also zero. (That is why the United States got more oomph from its zero interest rates than Japan, which had an inflation rate of zero or less.) 

As long as paper currency has an interest rate of zero, it is hard for other interest rates to go below zero, so the only way to get interest rates below inflation is to push inflation above zero. Take paper currency off its pedestal, and inflation is no longer necessary to provide this space for monetary policy, since interest rates can go down, instead of inflation having to go up. Then there is nothing standing in the way of ending inflation forever.

The Bottom Line for the Long-Run Inflation Target

Whatever the optimal target for long-run inflation is when there is a zero lower bound, the optimal target for long-run inflation is likely to lower in the absence of a zero lower bound. The overall benefit of repealing the zero lower bound is

  1. the benefit of repealing the zero lower bound would have if the long-run inflation target held fixed, PLUS

  2. the benefit of lowering the long-run inflation target from its previous value to whatever value is optimal in the absence of the zero lower bound. 

  3. I remain unimpressed by the purported benefits of inflation other than steering away from the zero lower bound. I will be surprised if a nation that repeals its zero lower bound does not also gradually lower its long-run inflation target to zero.

So, in theory at least, this could eliminate recessions if central banks are able to use negative rates to spur enough investment and spending to get the economy back to normal quickly. But you argue it could eliminate inflation too. How would that work?

Why do we have a 2 percent inflation target? Well, Bernanke says it’s because of the zero lower bound. We may need to get interest rates to be 2 percent below inflation, and if inflation is 2 percent, then you can get interest rates below inflation, but if it’s 0, you can’t get interest rates below inflation. The Fed is very clear about the fact that it chooses to do 2 percent inflation because it’s worried about the zero lower bound.

In practice, we’d choose zero inflation. In my presentation to central banks, I go through the costs and benefits of inflation, and other than steering away from the zero lower bound, there aren’t many benefits to it. There are people who quite seriously argue that we need inflation so companies can cut real wages when necessary, but other than that, steering clear of the zero lower bound is the big reason we have inflation. And there are a lot of reasons to not like inflation.

There are some quite serious proposals to raise our level of inflation. 2 percent isn’t enough, because we still run into the ZLB. Larry Ball, Brad DeLong, Paul Krugman, Ken Rogoff — they’ve all proposed this. There are quite serious voices calling for four percent rather than two; that’s the number they hit on.

With electronic money, you get the benefit of inflation, of steering clear from the zero lower bound, without the destructive aspects. With inflation, you’re constantly changing your economic yardstick. Using Greg Mankiw’s example, suppose we said a yard is 36 inches today, but next year it’s 35 inches. That’s a big miss. The thing you’re measuring in is the electronic dollar, and if there’s zero inflation there, you have a constant yardstick.