Con The Central Bank Should Not Aim For Zero Inflation

Although price stability may be desirable, the benefits of zero inflation compared to moderate inflation are small, whereas the costs of reaching zero inflation are large. Estimates of the sacrifice ratio suggest that reducing inflation by 1 percentage point requires giving up about 5 percent of one year's output. Reducing inflation from, say, 4 percent to zero requires a loss of 20 percent of a year's output. At the current level of gross domestic product of about $9 trillion, this cost translates into $1.8 trillion of lost output, which is about $6,500 per person. Although people might dislike inflation, it is not at all clear that they would (or should) be willing to pay this much to get rid of it.

The social costs of disinflation are even larger than this $6,500 figure suggests, for the lost income is not spread equitably over the population. When the economy goes into recession, all incomes do not fall proportionately. Instead, the fall in aggregate income is concentrated on those workers who lose their jobs. The vulnerable workers are often those with the least skills and experience. Hence, much of the cost of reducing inflation is borne by those who can least afford to pay it.

Although economists can list several costs of inflation, there is no professional consensus that these costs are substantial. The shoeleather costs, menu costs, and others that economists have identified do not seem great, at least for moderate rates of inflation. It is true that the public dislikes inflation, but the public may be misled into believing the inflation fallacy—the view that inflation erodes living standards. Economists understand that living standards depend on productivity, not monetary policy. Because inflation in nominal incomes goes hand in hand with inflation in prices, reducing inflation would not cause real incomes to rise more rapidly.

Moreover, policymakers can reduce many of the costs of inflation without actually reducing inflation. They can eliminate the problems associated with the nonindexed tax system by rewriting the tax laws to take account of the effects of inflation. They can also reduce the arbitrary redistributions of wealth between creditors and debtors caused by unexpected inflation by issuing indexed government bonds, as in fact the Clinton administration did in 1997. Such an act insulates holders of government debt from inflation. In addition, by setting an example, it might encourage private borrowers and lenders to write debt contracts indexed for inflation.

Reducing inflation might be desirable if it could be done at no cost, as some economists argue is possible. Yet this trick seems hard to carry out in practice. When economies reduce their rate of inflation, they almost always experience a period of high unemployment and low output. It is risky to believe that the central bank could achieve credibility so quickly as to make disinflation painless.

Indeed, a disinflationary recession can potentially leave permanent scars on the economy. Firms in all industries reduce their spending on new plants and equipment substantially during recessions, making investment the most volatile component of GDP. Even after the recession is over, the smaller stock of capital reduces productivity, incomes, and living standards below the levels they otherwise would have achieved. In addition, when workers become unemployed in recessions, they lose valuable job skills. Even after the economy has recovered, their value as workers is diminished. Some economists have argued that the high unemployment in many European economies during the past decade is the aftermath of the disinflations of the 1980s.

Why should policymakers put the economy through a costly, inequitable disinflationary recession to achieve zero inflation, which may have only modest benefits? Economist Alan Blinder, whom Bill Clinton appointed to be vice chairman of the Federal Reserve, argued forcefully in his book Hard Heads, Soft Hearts that policymakers should not make this choice:

The costs that attend the low and moderate inflation rates experienced in the United States and in other industrial countries appear to be quite modest—more like a bad cold than a cancer on society. . . . As rational individuals, we do not volunteer for a lobotomy to cure a head cold. Yet, as a collectivity, we routinely prescribe the economic equivalent of lobotomy (high unemployment) as a cure for the inflationary cold.

Blinder concludes that it is better to learn to live with moderate inflation.

I QUICK QUIZ: Explain the costs and benefits of reducing inflation to zero. Which are temporary and which are permanent?

"My share of the government debt is $14,000."
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