What is Inflation? Why Do We Care?

The following is a continuation of last week’s posts (Basics of Money and Fiat Money) from economics professor, Art Carden. This week’s post explores the issue of monetary inflation and examines why it matters to an economy and its currency holders.

Once, during a middle-of-the-night conversation in college, we started talking about which Force powers we would use if we had command over the Force. As an economics major interested at the time in money and banking, I said that I would want "Force price stability." In short, I would use the Force to maintain a stable price level.

Price stability is one of the three major goals of macroeconomic policy (the other two are growing output and full employment). Its importance is evident from financial and economic news: if you turn on the radio or a financial news network like CNBC, you might hear about how some economists are worried about inflation in response to a strong jobs report or why the specter of deflation might haunt the United States or Europe.

In the last few decades, price levels have tended to rise rather than fall, and governments have strong incentives to pursue inflationary policies. Therefore, economists have mostly focused on inflation. Indeed, textbooks usually talk about the importance of not allowing inflation to get out of hand. Central bankers judge their performance in part by their ability to keep inflation low, and as the economist Justin Wolfers points out in this tweet (accompanied by a handy chart), "The Fed’s preferred inflation measure…has now been at or below its 2% target for 68 months."

6 Things You Should Know About Inflation

1. It Causes a Redistribution of Resources

Why do people worry about inflation? First, inflation redistributes resources from creditors to debtors (though this is a transfer from one group to another, not necessarily a cost to society). Interest rates incorporate people’s expectations about inflation, so if my mortgage is 3.25% and the inflation rate is 1.25%, then my bank is earning a real rate of 2% and an additional 1.25% to make up for the falling purchasing power of the dollars with which I am repaying the loan. If the inflation rate suddenly jumps to 2% and the nominal interest rate is fixed, the bank’s real return falls to 1.25%. This is good news for me (but bad news for the bank) because I am making the same monthly payment every year with dollars that are worth less than we expected them to be.

2. It’s an Indicator of Economic Health

Second, low inflation can also be an indicator of an institutional environment that is conducive to growth while high inflation can be an indicator of an institutional environment that is not. Governments like having command over real resources, and they can obtain command over real resources by taxing, by borrowing, or by simply printing money and forcing people to take it. Calvin Coolidge said that "inflation is repudiation" because a government that pays its debts by printing money returns to its creditors dollars that are worth less than the dollars the government originally borrowed and at a lower real interest rate than was originally agreed to.

Inflation has been called "the cruelest tax" because it is harder to see than other taxes and harder to trace to the government. When the government raises your taxes, it shows up in every paycheck and you feel it every April 15th. When the government finances its activities, the cost shows up on your grocery bill rather than your tax bill. This makes it easier to blame not the people causing the inflation (the government monetary authorities running the printing press), but the merchants and businesspeople who are responding to higher expressed demand for their products by raising prices. This can lead to positively destructive policies like price controls and persecution of businesspeople, as has recently happened in Venezuela. The temptation to print money to cover deficits can be tempting, even overwhelming in some places, so a low rate of inflation is a marker of fiscal and monetary discipline.

3. Menu Costs

These issues aside, inflation has other real costs. When inflation is low, you don’t have to change prices very often. Economists call the real costs of changing prices "menu costs." Consider a restaurant. If inflation is low, then a restaurant won’t have to reprint its menu very often. In a higher-inflation environment, restaurants have to reprint their menus more frequently, and printing menus consumes real resources (ink, paper, etc.) that could have been used for other things had they not been used to reprint menus. Across the economy, changing prices frequently consumes resources that could be used for other things.

4. Shoeleather Costs

When inflation is low, it isn’t very costly to hold your wealth as money or as non-interest bearing (or very low-interest) bank deposits. I keep some change in the car for parking meters and the like; at an inflation rate of 1.4% the change in my car isn’t depreciating rapidly enough to cause me much concern. I can hold cash and (non-interest-bearing) gift cards in my wallet without fearing that they will depreciate too rapidly. If the inflation rate were much higher and if prices were rising rapidly, I wouldn’t carry cash and gift cards. I would want to hold more assets with higher interest rates. This would mean more trips to the bank and to the ATM. Economists call the costs of managing your cash balances "shoeleather costs" because someone running back and forth between his house and the bank would wear out more shoes.

5. It Causes Tax Distortions

Inflation also interacts with the tax system to distort the decisions people make. Taxes are usually paid based on nominal values, not real values, and a high inflation rate can lead to a very large tax bite. Inflation means that "bracket creep"—where inflation pushes people into higher tax brackets even though their real incomes haven’t changed—is an important problem. It can also mean a net consumption of the capital stock. The capital gains tax, for example, taxes nominal increases rather than real increases in the value of assets.

Suppose you buy stocks for $100,000 and sell them a year later for $110,000. Suppose the inflation rate was 10%. In that case, you have earned a real return of 0%: adjusted for inflation, the stocks you sell in a year have the same value as they did when you bought them. In the eyes of the taxing authority, however, this is not the case. If the capital gains tax is 20%, then you owe the government $2,000 even though your real return was actually zero. Financial planners and others have come up with a lot of ways to deal with inflation, but the time and energy they have spent doing so represent one of the costs of inflation. If prices were stable, that time and energy would have been available for other things.

6. It Creates Confusion

Perhaps most importantly, inflation distorts people’s decisions because it adds noise and confusion to the decisions people are making. It is easier to plan and invest for the very long term if prices are stable; volatile inflation can therefore make people more short-sighted than they would otherwise be. Unanticipated changes in inflation distort the information content of prices, as well. Suppose a corn farmer sees that prices are rising. Should he plant more corn? In other words, are the rising prices due to a real increase in demand for corn, or are they simply due to the fact that there is now more money chasing fewer goods? If the rising prices are solely due to inflation, the farmer might produce too much corn. As we have discussed, a government distorting interest rates by printing too much money can also create a business cycle.

Summary

Three marks of a healthy economy are high output, full employment, and stable prices (or just "low inflation"). When inflation gets too high, it might be a marker of an unsound institutional environment. Inflation can also be costly as it requires people to consume real resources changing prices, managing the amount of money they keep on hand, and dealing with the uncertainties created by an inflationary environment. For these reasons and others, it is important to keep inflation under control.

Here is a brief video from the Foundation for Economic Education in which Steve Horwitz explains the costs of inflation.