Happiness and Economics: How the Economy and Institutions Affect Human Well-Being

CHAPTER 6 Inflation

Chapter 6 INFLATION 6.1 Introduction An increase in the general price level—inflation—is disliked by the population. But a lot depends on what kind of inflation takes place. When the price increase is anticipated, individuals can adjust to it. They can make contracts that take into account that prices will be higher in the future. In particular, they will ask for a wage increase in the future in order to compensate for the loss in purchasing power of money. In contrast, if inflation is not anticipated or comes as a shock, such adjustment is not possible. Wage earners, as well as owners of nominal assets such as cash or bonds, risk being the losers. Economics starts with this distinction between anticipated and unanticipated inflation when analyzing how inflation affects individuals . Adjustment is the more costly, the higher is the variability in aggregate inflation and in relative prices caused by an increase in inflation. People then must invest a lot of effort in informing themselves about, and insulating themselves from, the expected price increases. They may make various errors, such as underestimating the extent of future inflation or how a particular price changes compared to other prices. The costs of inflation have been divided into assorted categories (Fischer and Modigliani 1978): (a) Costs that would persist even in an economy in which all prices are indexed (i.e., in which no relative price changes and no real income losses exist). They consist of “shoe-leather” or “trips to the bank” costs when people try to save on currency, and in “menu” costs when suppliers have to change their prices and then print new price lists. (b) Costs due to running government and private institutions established to deal with changing prices. 112 CHAPTER 6 (c) Costs produced by the inability to change contracts specified in nominal terms. (d) Costs due to the effects of uncertainty about future inflation. (e) Costs caused by government in its efforts to control and suppress inflation. These may consist, for instance, of the imposition of price controls by the state, leading to distortions in relative prices and hampering economic growth. Even more important, heavy costs may be incurred as a result of restrictive fiscal and monetary policy, causing unemployment and real income losses. Depending on a number of rather restrictive assumptions, the welfare costs of rising prices can be captured by computing the appropriate area under the money demand curve, the basic idea being that economizing on the use of currency imposes costs in terms of wellbeing . They are reflected indirectly by the demand-for-money curve. Based on this method, the cost of a 10 percent annual inflation has been calculated to be between 0.3 percent and 0.45 percent of national income (Fischer 1981, Lucas 1981). This is very little and suggests that an anti-inflationary policy is rarely worth the cost it entails in terms of additional unemployment and real income loss. But many economists would strongly disagree with this conclusion. They point out that stable prices are a crucial prerequisite for a sound economy in which suppliers and demanders can rationally act. High inflation is seen to be the result of high government budget deficits, frequently caused by wars or internal political instability. A state’s capacity to finance the budget deficit by floating debt is limited, as the costs in terms of interest to be paid soar, and, finally, nobody is prepared to buy the public bonds any longer. Neither is it endlessly possible to finance the budget deficit by printing money, because the population switches from the internal currency—which is constantly, and ever more rapidly, losing value—to a stable foreign currency (in South America often the U.S. dollar; in Europe, before the introduction of the Euro, the German Mark), or people use goods (such as cigarettes) to perform transactions. As a consequence, high inflation invariably leads to restrictive fiscal and monetary policies with their own high costs. Most economists take an intermediate position, not least because the empirical evidence on the costs of inflation is far from clear. There is no convincing evidence that a higher rate of anticipated inflation leads to a higher variability in aggregate inflation or in relative prices. INFLATION 113 Neither is there strong econometric evidence...