Imagine that we took a poll and asked people the following question: "This year the yard is 36 inches. How long do you think it should be next year?" Assuming we could get people to take us seriously, they would tell us that the yard should stay the same length—36 inches. Anything else would just complicate life needlessly.
What does this finding have to do with inflation? Recall that money, as the economy's unit of account, is what we use to quote prices and record debts. In other words, money is the yardstick with which we measure economic transactions. The job of the Federal Reserve is a bit like the job of the Bureau of Standards—to ensure the reliability of a commonly used unit of measurement. When the Fed increases the money supply and creates inflation, it erodes the real value of the unit of account.
It is difficult to judge the costs of the confusion and inconvenience that arise from inflation. Earlier we discussed how the tax code incorrectly measures real incomes in the presence of inflation. Similarly, accountants incorrectly measure firms' earnings when prices are rising over time. Because inflation causes dollars at different times to have different real values, computing a firm's profit—the difference between its revenue and costs—is more complicated in an economy with inflation. Therefore, to some extent, inflation makes investors less able to sort out successful from unsuccessful firms, which in turn impedes financial markets in their role of allocating the economy's saving to alternative types of investment.
A SPECIAL COST OF UNEXPECTED INFLATION: ARBITRARY REDISTRIBUTIONS OF WEALTH
So far, the costs of inflation we have discussed occur even if inflation is steady and predictable. Inflation has an additional cost, however, when it comes as a surprise. Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need. These redistributions occur because many loans in the economy are specified in terms of the unit of account—money.
Consider an example. Suppose that Sam Student takes out a $20,000 loan at a 7 percent interest rate from Bigbank to attend college. In ten years, the loan will come due. After his debt has compounded for ten years at 7 percent, Sam will owe Bigbank $40,000. The real value of this debt will depend on inflation over the decade. If Sam is lucky, the economy will have a hyperinflation. In this case, wages and prices will rise so high that Sam will be able to pay the $40,000 debt out of pocket change. By contrast, if the economy goes through a major deflation, then wages and prices will fall, and Sam will find the $40,000 debt a greater burden than he anticipated.
This example shows that unexpected changes in prices redistribute wealth among debtors and creditors. A hyperinflation enriches Sam at the expense of Bigbank because it diminishes the real value of the debt; Sam can repay the loan in less valuable dollars than he anticipated. Deflation enriches Bigbank at Sam's expense because it increases the real value of the debt; in this case, Sam has to repay the loan in more valuable dollars than he anticipated. If inflation were predictable, then Bigbank and Sam could take inflation into account when setting the nominal interest rate. (Recall the Fisher effect.) But if inflation is hard to predict, it imposes risk on Sam and Bigbank that both would prefer to avoid.
This cost of unexpected inflation is important to consider together with another fact: Inflation is especially volatile and uncertain when the average rate of inflation is high. This is seen most simply by examining the experience of different countries. Countries with low average inflation, such as Germany in the late twentieth century, tend to have stable inflation. Countries with high average inflation, such as many countries in Latin America, tend also to have unstable inflation. There are no known examples of economies with high, stable inflation. This relationship between the level and volatility of inflation points to another cost of inflation. If a country pursues a high-inflation monetary policy, it will have to bear not only the costs of high expected inflation but also the arbitrary redistributions of wealth associated with unexpected inflation.
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