The Costs of Inflation - What Have We Learned?

By Gillmore, David | The Reserve Bank of New Zealand Bulletin, September 2008 | Go to article overview

The Costs of Inflation - What Have We Learned?


Gillmore, David, The Reserve Bank of New Zealand Bulletin


This article reviews what we know about the long-run impact of inflation on economic growth. Economic theory tells us that both high inflation and deflation adversely affect the economy. Inflation tends to benefit the wealthy at the expense of the poor and those on fixed incomes and it reduces economic growth over the long term. The experiences of New Zealand and other industrialised countries since World War II generally support this negative long-term relationship between inflation and growth. The experience of Japan illustrates the negative impact of deflation. There is general agreement that both high inflation and deflation impact negatively on the economy. Recent empirical studies have estimated the level of inflation at which its long-run impact on growth becomes materially negative. For industrialised countries, this level is about 3 percent, while for developing countries it is around 11 to 12 percent.

1 Introduction

Our economic system will work best when producers and consumers, employers and employees, can proceed with full confidence that the average level of prices will behave in a known way in the future - preferably that it will be highly stable.

Milton Friedman (1)

One of the basic principles of economics is that inflation is bad for economic growth. There is strong evidence that very high inflation is damaging to an economy - as was seen in Germany in the 1920s and currently in Zimbabwe. Equally, negative inflation (deflation) appears to be incompatible with healthy economic growth, as in Japan during the 1990s and early this decade. It seems clear that both high inflation and deflation impact negatively on a society's standard of living and on individuals' quality of life. But "there is less conclusive evidence whether moderate inflation is harmful or not". (2)

This article discusses the reasons why inflation is bad for an economy. Section 2 summarises the reasons economists give for how inflation impacts on the economy. These include redistributive costs (inflation benefits some people at the expense of others) and negative effects on the level of output and the rate of growth (inflation creates damaging inefficiencies in the economy). In line with much of the literature, in this paper we focus on inflation's effects on growth.

How do the data support this theory? In section 3, the record of inflation and economic growth in industrialised countries since the end of World War II reveals that periods of low inflation have generally been associated with higher and more stable growth than when inflation has been high and variable.

Section 4 summarises the findings of studies that use sophisticated econometric techniques that aim at verifying the impact of inflation on economic activity. These techniques take account of other factors that may drive both inflation and output growth and influence the correlations observed in the data. Recent studies have estimated the rates of inflation above which the negative effects of inflation appear. Section 5 concludes.

2 Costs of inflation: theoretical arguments

This section summarises theoretical arguments concerning the negative long-run impacts of inflation on the economy. (3) In general, inflation impacts negatively on growth and the distribution of income or wealth. The impact of inflation depends on whether it is anticipated or not. Anticipated inflation impacts negatively on growth, through the cost of changing prices, the cost of holding cash, and variability in relative prices. Through the tax system, it also reduces real value of savings and fixed incomes. Unanticipated inflation has both redistributive consequences and negative effects on growth. (4)

The impact of anticipated inflation on economic activity and growth

The higher the general rate of inflation, the more often firms must change prices. This comes at a cost, whether in printing new menus, re-pricing of items on display in retail stores, updating computer files, or in the potential negative impact on customer loyalty. …

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