Academic journal article Economic Commentary (Cleveland)

Rethinking the Welfare Cost of Inflation

Academic journal article Economic Commentary (Cleveland)

Rethinking the Welfare Cost of Inflation

Article excerpt

During the past 25 years, average inflation in advanced countries has fallen, from 9 percent in the first half of the 1980s to 2 percent since 2000. The same disinflation trend has been observed among developing countries, where inflation fell from 31 percent in the first half of the 1980s to less than 6 percent since 2000 (see figure 1). This phenomenon is even more remarkable if one looks at Latin America and transition economies over the past 10 years: Inflation has been reduced from threedigit numbers (more than 100 percent) to about 10 percent in 2003. This "global disinflation," as economist Kenneth Rogoff calls it, has occurred thanks to institutional changes such as greater independence of central banks, improved monetary regimes, and better macroeconomic policies. However, none of these changes is costless. The United States, for example, went through a major recession and a period of high unemployment during the early 1980s as inflation was brought down. For this process to be worthwhile, it must be the case that even moderately high inflation rates of, say, 10 percent, generate substantial costs to society.

Yet assessing the costs of long-run inflation has proved difficult. A wide variety of estimates has been proposed. At the outset of the 1980s, Stanley Fischer suggested that the annual cost of 10 percent inflation was about 0.3 percent of gross domestic product (GDP) every year, while Nobel Prize winner Robert Lucas figured it was about 0.45 percent of GDP. More recently (2000), Lucas revised his estimate upward, to slightly less than 1 percent of GDP. Some economists believe that even this last number underestimates the true cost of inflation. Ricardo Lagos and Randall Wright are a case in point. Their recent study (to be published in 2005) gives measures for the welfare cost of inflation ranging from 1 to 5 percent of GDP. To put this in context, consider the median U.S. household. It earns about $45,000 a year. The cost of inflation for this household, according to these estimates, would be between $450 and $2,250 a year.

This Commentary presents the ways economists see and measure the costs of anticipated inflation. We will first describe the idea of the "welfare triangle"-the traditional method used to capture the problem and generate the cost estimates. It was developed by Martin Bailey and used subsequently by Milton Friedman (another Nobel Prize winner), Stanley Fischer, and Robert Lucas. Then we will take a look at the strategy Lagos and Wright developed. It is based on an entirely different approach-the search model of monetary exchange. This new approach yields a surprising result: We will see that inflation may be more costly than economists used to think.

* The "Welfare Triangle"

Money provides some services to society by facilitating exchange. The cost of inflation corresponds to a reduction in these services. Because inflation erodes the purchasing power of money balances, individuals tend to conduct their transactions with fewer money balances as the inflation rate increases. For instance, they resort to alternative payment arrangements, such as credit or barter, which can be less efficient or more costly. They also buy the services of financial intermediaries to help manage their cash balances. Milton Friedman offers the following example, one that gave rise to the term shoe-leather cost of inflation: "A retailer can economize on his average cash balances by hiring an errand boy to go to the bank on the comer to get change for large bills tendered by customers. When it costs ten cents per dollar per year to hold an extra dollar of cash, there will be a greater incentive to hire the errand boy, that is, to substitute other productive resources for cash" (1969, p. 14). In all cases, real resources are spent in an effort to avoid the costs associated with holding non-interest-bearing money balances, and, in Robert Lucas's words, these resources "are simply thrown away, wasted on a task that should not have been performed at all" (2000, p. …

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