Why inflation is costly
The microeconomic consequences of a macroeconomic phenomenon
Inflation is back, after a long time in hiding! I’ve recently fielded a few questions from people who’ve never experienced high inflation; it was they who encouraged me to write this post. Those with long — and reliable — memories need read no further. For others, I hope this is a useful primer or refresher.
Why worry about inflation?
Why worry about inflation? After all, if 2% is OK — or even ideal — for the economy, then why would 8%, 12% or even 16% be bad?
Macroeconomics doesn’t provide a good answer to this question. But microeconomics does, and that answer involves uncertainty, risk and incomplete contracts.
Price changes are a good thing
It is normal for prices to change over time. Resource scarcity tends to push prices up. Technology and global trade tend to push them down. Regulation can go either way — quality controls tend to increase prices, whereas competition controls aim to reduce them.
Economists generally regard price changes as a good thing. A rising price signals scarcity — incentivising consumers to reduce consumption and find substitutes, and encouraging producers to innovate to reduce costs. Similarly, a falling price signals abundance — discouraging excess production, while encouraging consumer substitution away from pricier alternatives. Unresponsive prices can lead to wastage, over-consumption, shortages and queuing.1
But changes in the price level are not so good
What do I mean by the price level? I think of it as the “price” of money, measured by what it can purchase. For example, if $500/week was buying the food, transport, heating etc. for your household in 2021, but you are spending $550/week for those same things in 2022, then the price level (with respect to your household’s purchases) has changed by $50/week, or 10%.
The price level matters because we use money for two very important things: as a unit of exchange and as a store of value. Changes in the price level, particularly unexpected or poorly predicted changes, undermine the usefulness of money for these purposes.
Inflation is when a fixed amount of money buys less
More specifically, inflation is when the purchasing power of a currency declines across a “basket” typical of the purchases of a specified group of people or firms. The most common measure is the consumer price index (CPI), which covers goods and services purchased by households, in the quantities purchased (on average) of those goods and services.2 In its simplest form, the CPI is the change in the price of that basket, compared with a year earlier.
For workers, inflation means lower consumption unless their wages rise by a corresponding amount. For firms, inflation means higher costs and thus lower profits, unless their revenue also rises. Inflation erodes the value of assets (e.g. cash and invoices not yet received) and liabilities (e.g. mortgages and tax not yet paid).
Some countries have experienced hyperinflation. For example, inflation rates reached 489,000,000,000% in Zimbabwe in 2008, and 929,790% in Venezuela in 2018, according to the IMF.
Inflation is costly because it creates financial risks
But inflation at much more mundane rates can still cause problems. Buying a home, choosing a career, or starting a business is a financially risky proposition for most of us — even more so if we can’t reliably predict our future income and the costs (e.g. interest) we will face. Financial uncertainty, and the possibility of economic ruin, tends to deter people from making purchases and starting enterprises, which would likely benefit them and others.
Inflation tends to cause problems because some prices are sticky (e.g. employment contracts are specified in nominal dollars), yet others are flexible (e.g. variable interest-rate mortgages).
High inflation also has redistributive consequences
Those on fixed nominal incomes suffer financially from high inflation. As do those reliant on savings. High inflation in NZ during the 1970s and early 80s impoverished a generation of elderly who thought their savings would provide for their own future.
When inflation rises, long-term contracts at fixed prices favour customers at the expense of suppliers. And borrowers with fixed-interest mortgages benefit at the expense of lenders. Knowing this, suppliers and lenders may be reluctant to offer such products, or only do so with a price premium to cover their increased financial risk.
If inflation was predictable, would the rate matter?
While we know the current (or immediate past period) inflation rate, we know much less about future inflation rates.
But what if we did know the future inflation rate? Let’s say that everyone could agree that the inflation rate would be fixed at 12% per year for the next 10 years. To compensate:
supermarkets could adjust their prices by around 1% a month
employment contracts could contain a clause that increased wages by (at least) 1% a month
governments could adjust pensions, benefit payments, benefit eligibility thresholds, fines, tax thresholds etc. automatically3
commercial contracts could adjust all relevant payments by 1% a month
rental agreements could adjust rents by 1% a month (and likewise for bonds, penalties, etc.)
interest rates, reflecting the diminishing value of the money lent or borrowed, would settle somewhere above 12%.4
and so on
Presumably no-one would hoard cash — it would lose half its value in just five years!
Predictable, stable inflation would add complications to many laws and most contracts.
Further, there are complex interactions between inflation and the tax system, which, if not addressed, could cause less-than-desirable consequences. A New Zealand example is the tax treatment of interest received by savers, who are taxed on both the “inflation” and “real income” components of interest. Taxation receipts rise in line with the inflation rate, eroding the real income of the saver. Similarly, inflation affects real estate and business investment differently, and previous bouts of high inflation have favoured the former over the latter.
But once (and if) the necessary contractual and legal plumbing was in place and well understood, everyone would get on with life, commerce and government. Inflation would add to cognitive and transaction costs, but not, of itself, create uncertainty and financial risk for those buying and selling assets, goods and services.
Could a varying inflation rate be handled contractually?
Ten years with a fixed inflation rate is not sufficiently long to be useful for many purposes. And government pensions can last more than one lifetime — the last American receiving a Civil War pension died in 2020, 155 years after the war’s end. Needless to say, inflation had eroded the value of her pension to just $878 a year.
So rather than trying to pin down the inflation rate, perhaps every contract and law could include “inflation adjustment” clauses, based on the CPI or other price index. This seems plausible, though more complex than adjusting by a fixed rate.
But would it eliminate financial risks? Theory tells us that contracts are incomplete, that is, they fail to specify actions and transfers for at least some (possibly unforeseen) contingencies. And the more complex and longer term the contracts, the higher likelihood that such contingencies will arise.
What inflation rate would we choose?
If we could choose and agree on a future inflation rate, then surely we’d choose a small one. Why, do you ask? Well, if we chose say 2%, then suddenly getting the inflation clauses correct in every contract and law wouldn’t matter nearly so much, simply because the consequences of not adjusting for 2% inflation are near insignificant (except over long timeframes).
Following this microeconomic logic, a zero inflation rate would be even more ideal.5 But for macroeconomic reasons, modern inflation targeting institutions typically choose target rates in the low single digits.6
Having chose a target rate, the real magic (drawing of course, on both micro and macro economic theory) is in the design and operation of the institutions that gets and keeps the inflation rate near this target. New Zealand was once a leader in this field, though success has been elusive of late. A topic for a future post!
Zero prices are the ultimate in unresponsive prices, and they typically lead to wastage, over-consumption, shortages and queuing. See my post on the economics of hospital emergency care.
Statistics agencies also report producer price indices (PPIs), in which the basket is the inputs to a specific industry.
Some benefit payment rates are adjusted automatically under New Zealand law. Automatic adjustment of other rates, thresholds etc. can be politically controversial, especially the thresholds for personal income tax.
Interest rates can be usefully decomposed into three components, which add together to form the final rate. The components are (a) inflation, which adjusts for the reduced purchasing power of the capital; (b) rent, i.e. compensation to the lender for use of their capital; and (c) a risk premium, as not all capital gets repaid (e.g. due to borrower default). Higher inflation rates directly translate into higher interest rates through (a), and indirectly via (c).
Many argue that CPI measurements is are biased upwards they fail to properly account for advances in technology, quality and product variety, nor for consumer’s ability to substitute away from higher priced products and retailers. See, e.g., Patrick Sabourin (2012) Measurement Bias in the Canadian Consumer Price Index: An Update and Paul Schreyer (2019) Measuring Consumer Inflation in a Digital Economy. Estimates of this bias typically fall in the range 0.5 to 1.0%. Taking the upper bound, a 1% CPI corresponds to a “true” consumer price inflation rate of zero.
There is a large quantity of research on optimal inflation rates. See, for example, Stephanie Schmitt-Grohe & Martin Uribe (2010) The optimal rate of inflation. The US Federal Open Market Committee explains that a target of 2% over the longer run
is most consistent with the Federal Reserve’s mandate for maximum employment and price stability. When households and businesses can reasonably expect inflation to remain low and stable, they are able to make sound decisions regarding saving, borrowing, and investment, which contributes to a well-functioning economy.
… inflation that is too low can weaken the economy. When inflation runs well below its desired level, households and businesses will come to expect this over time, pushing expectations for inflation in the future below the Federal Reserve’s longer-run inflation goal. This can pull actual inflation even lower, resulting in a cycle of ever-lower inflation and inflation expectations.
If inflation expectations fall, interest rates would decline too. In turn, there would be less room to cut interest rates to boost employment during an economic downturn. Evidence from around the world suggests that once this problem sets in, it can be very difficult to overcome.
My thanks to Murray Sherwin, Judy Kavanagh and Paul Walker for comments on earlier drafts of this post. Errors and opinions are my own.