Academic journal article Economic Review - Federal Reserve Bank of Kansas City

The Long-Run Costs of Moderate Inflation

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

The Long-Run Costs of Moderate Inflation

Article excerpt

Long-run price stability is generally considered to be a primary goal of monetary policymakers in many countries. One reason policymakers care about inflation is that it can harm economic performance. Numerous studies of the impact of inflation on economic performance have focused on whether increases in inflation reduce economic growth in the long run (Barro, Fischer 1993, Bruno and Easterly, and Clark). These studies have found that prolonged high inflation does in fact reduce economic growth, but they were not able to detect a significant long-run relationship between real growth and low or moderate inflation. Because anti-inflationary policies typically have short-run costs, such as higher unemployment and slower economic growth, the results from these studies may lead people to ask whether such policies are appropriate when inflation is low or moderate.

It is contended here that anti-inflationary policies may be appropriate, even if low to moderate longrun inflation does not reduce long-run growth, if inflation harms the economy in other ways. Three potentially harmful consequences of inflation are considered: (1) inflation uncertainty, (2) real growth variability, and (3) relative price volatility. These consequences are costly because they reduce economic efficiency-and therefore the level of economic output-and consumer welfare.

This article discusses the costs of inflation uncertainty, real growth variability, and relative price volatility, and examines their empirical relationship with inflation. The article shows that inflation uncertainty, real growth variability, and relative price volatility all tend to rise as long-run inflation rises from low to moderate levels. As a result, it is concluded that policymakers may find it justifiable to pursue anti-inflationary policies even when inflation is low.

DOES INFLATION UNCERTAINTY RISE WITH INFLATION?

One possible consequence of rising inflation is that inflation uncertainty may also rise. Inflation uncertainty is costly to an economy because it can lead to higher real interest rates, which in turn reduces real economic activity and consumer welfare. However, inflation may not be associated with greater inflation uncertainty if inflation is only moderate. This section discusses the costs of inflation uncertainty and shows that inflation uncertainty is higher in countries with moderate long-run inflation rates than in countries with low long-run inflation rates.1

Why is inflation uncertainty costly?

To understand how inflation uncertainty raises real interest rates, it is useful to consider how nominal interest rates respond to expected price increases. A simple example involves the purchase of a 1-year Treasury bill. If there were no uncertainty about inflation, the nominal interest rate on the bill would equal the sum of the real return required by investors to purchase the bill and the expected inflation rate over the 1-year investment horizon. The real return is the amount that investors would require in order to part with their money for a year in the absence of inflation. With inflation, however, the bill's principal will purchase fewer goods and services at the end of the year than at the beginning. For the principal to buy the same amount of goods and services when the bill matures, the return on the bill must be boosted by the inflation rate. Since the interest rate is determined when the bill is purchased, the interest rate can only incorporate the expected inflation rate as opposed to the actual inflation rate.

Accounting for expected inflation still may not fully insulate investors or borrowers from the risk of inflation because actual and expected inflation are rarely equal. If actual inflation turns out to be greater than expected, then the investor's real return is less than initially anticipated. Conversely, if actual inflation is less than expected, borrowers end up paying more than is necessary to compensate investors for the loss of purchasing power caused by inflation. …

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