Academic journal article Journal of Money, Credit & Banking

Contracting Costs, Inflation, and Relative Price Variability

Academic journal article Journal of Money, Credit & Banking

Contracting Costs, Inflation, and Relative Price Variability

Article excerpt

A LARGE LITERATURE examines the relation between inflation and relative price variability.(1) This literature derives its importance from the belief that, if higher inflation leads to higher relative price variability, the welfare cost of inflation is greater than otherwise.(2) Earlier research predicated on this belief has focused mainly on the costs of increased relative price variability arising from the necessity to adjust prices more often and from the wrong decisions made by economic agents when prices are misleading.(3) In this paper, we investigate the question of whether greater relative price variability leads to greater contracting costs and hence lower economic efficiency. The stylized fact we try to explain is that, as inflation increases, there is a decrease in the use of long-term contracts. We show that greater relative price variability, under some conditions, makes long-term contracts, especially those supported by reputation, more expensive relative to spot contracts. Further, we argue that in the presence of long-term contracts, greater price-level volatility leads to an increase in contracting costs.

To make our point, we focus on a widely used contract and study how the conditions under which that contract is self-enforcing are affected by relative price variability. In this contract, a risk-neutral limited liability firm, the buyer, promises to buy a good at a future date from a risk-averse individual, the seller, at a price set at the time of contracting.(4) Examples of such contracts are labor contracts where the buyer promises a fixed wage to workers for several periods of time or agricultural contracts where the buyer promises to buy the harvest at a fixed price. Forward and futures contracts are other examples of such contracts, where the risk-averse sellers benefit because the buyers bear risk that the sellers would be saddled with if they were to use the spot market to sell the good. These contracts reduce risk for the sellers only insofar as the buyers fulfill their obligations, but the buyers will always be tempted to act opportunistically at the time that the good is supposed to be delivered if they can buy the good more cheaply on the spot market. For instance, with the labor contract, the buyers might want to walk away from the contract if the price of labor falls so that new workers can be hired at lower wages.

If prices are stable, there are fewer incentives for buyers not to honor contracts because the spot price is likely to be close to the long-term contract price. At the same time, however, if prices are stable, such contracts have little benefit. With volatile prices, the spot price when the good has to be delivered may be very different from the long-term contract price. When the spot price is much lower than the long-term contract price, there is considerable temptation for the buyer to walk away from the contract. In this paper, we focus on the case where the seller cannot enforce the contract using the courts. A simple argument why this may be so is that the use of the courts may be too expensive and the outcome too uncertain. In our analysis, we simply assume that the buyer is a limited liability firm that can pay a liquidating dividend just before the long-term contract has to be executed. With this assumption, we can focus on our main point without adding unnecessary complications. It should be noted, however, that rather than simply defaulting on long-term contracts, buyers are often more likely to seek ways to renegotiate contracts to decrease their losses relative to using the spot market. For instance, when gas prices were high, the Columbia Gas System committed to buy gas through long-term contracts. After gas prices fell, some of the contracts forced Columbia to acquire gas at five times the spot price. To reduce its losses, Columbia filed for bankruptcy to increase its bargaining power with its suppliers in its contract renegotiations. …

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