Macroeconomics — The Costs of Inflation, Expected and Unexpected

Macroeconomics — The Harm of Inflation Lies Less in Its Level than in Forecast Errors and Volatility

“Inflation is bad” is too broad a statement. If everyone expects 3% inflation and builds it into contracts, nominal wages and nominal interest rates both rise by 3% and real variables barely change. This chapter counts the costs of inflation separately for the expected and unexpected cases.

1. The costs of expected inflation

Some costs remain even when inflation is fully expected.

The costs of expected inflation
Cost	Description
Shoe-leather costs	The trouble of holding less money and withdrawing more often as the opportunity cost of cash rises
Menu costs	The cost of changing price tags, contracts and systems frequently
Relative-price distortion	Firms adjust prices at different times, so relative prices fluctuate for reasons unrelated to productivity
Distortions from unindexed taxes	Taxes on nominal income raise effective tax rates
Unit-of-account confusion	Long-term planning and accounting in money terms become harder

The tax distortion is larger than one might think. Suppose the nominal interest rate is 6%, inflation is 4% and the tax rate on interest income is 25%. The after-tax nominal return is 4.5%; subtracting inflation leaves an after-tax real return of 0.5%. Taxes take three-quarters of the 2% pre-tax real return. With 0% inflation and the same 2% real rate, the after-tax real return would be 1.5%. In the same real economy, inflation has raised the effective tax rate on saving from 25% to 75%.

2. Redistribution from unexpected inflation

Unexpected inflation and the real interest rate

r^{\text{ex post}} = i - \pi = (r^{\text{ex ante}} + \pi^e) - \pi = r^{\text{ex ante}} - (\pi - \pi^e)

If inflation is higher than expected, the realized real interest rate is lower than expected. Wealth is transferred from creditors to debtors by the difference.

Suppose a fixed-rate loan was made at a nominal rate of 5% with expected inflation of 3%, but actual inflation turns out to be 7%. The real rate the lender receives is −2%, 4 points below the expected 2%. On a loan of 100 million won, about 4 million won of purchasing power passes to the borrower in a year. People with nominally fixed wage contracts, pensions and deposits lose; fixed-rate borrowers and the government (the issuer of nominal bonds) gain.

Redistribution in itself sums to zero, since one side’s loss is the other’s gain. But when inflation is uncertain, every long-term nominal contract becomes risky. People avoid long-term contracts or demand risk premiums, and this hampers investment and financial development. Countries with high inflation also tend to have volatile inflation, so the real cost of high inflation lies in this uncertainty.

3. Hyperinflation

Inflation above 50% a month is commonly called hyperinflation. The cause is almost always a government financing its budget deficit by printing money. As people hold less money, more money must be printed to cover the same deficit, and inflation accelerates. This is the process by which the base of the inflation tax (Chapter 16) collapses. Hyperinflations have been stopped by fiscal reform and a credible change in the monetary regime.

4. Deflation

Falling prices are dangerous too. The real burden of nominal debt grows (the debt deflation of Chapter 15), and because nominal rates cannot fall far below zero, falling prices raise real interest rates. If people postpone spending while waiting for prices to fall further, demand falls further.

5. Why inflation targets are 2%

Why the target is 2% rather than 0%
Reason	Description
Measurement bias	The CPI overstates true inflation because of quality improvements and similar factors
Room above the lower bound	Higher average nominal rates leave room to cut in recessions
Downward nominal wage rigidity	A little inflation allows real wages to adjust
Avoiding deflation risk	A 0% target would often slip into deflation

Two per cent is a convention that balances these costs against the costs of inflation itself, not an exact optimum derived from theory. Some argue that the target should be higher to reduce the lower-bound problem further.

Check your understanding

With a nominal interest rate of 8%, a tax rate on interest income of 20% and inflation of 5%, what is the after-tax real return? The after-tax nominal return is 6.4%; subtracting inflation gives 1.4%. The pre-tax real return is 3%, so the effective tax rate is $(3-1.4)/3\approx 53\%$ . With 0% inflation and a nominal rate of 3%, the after-tax real return is 2.4% and the effective tax rate is 20%.

References

N. Gregory Mankiw, Macroeconomics, ch. 5
Phillip Cagan, “The Monetary Dynamics of Hyperinflation,” in Studies in the Quantity Theory of Money (1956)
Stanley Fischer and Franco Modigliani, “Towards an Understanding of the Real Effects and Costs of Inflation,” Weltwirtschaftliches Archiv (1978)
Bank of Korea, Monetary policy framework (Korean)