The Long-Run Costs of Moderate Inflation

By Hess, Gregory D.; Morris, Charles S. | Economic Review - Federal Reserve Bank of Kansas City, Second Quarter 1996 | Go to article overview

The Long-Run Costs of Moderate Inflation


Hess, Gregory D., Morris, Charles S., Economic Review - Federal Reserve Bank of Kansas City


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. …

The rest of this article is only available to active members of Questia

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Buy instant access to cite pages or passages in MLA 8, MLA 7, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

(Einhorn 25)

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Note: primary sources have slightly different requirements for citation. Please see these guidelines for more information.

Cited article

The Long-Run Costs of Moderate Inflation
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Help
Full screen
Items saved from this article
  • Highlights & Notes
  • Citations
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

matching results for page

    Questia reader help

    How to highlight and cite specific passages

    1. Click or tap the first word you want to select.
    2. Click or tap the last word you want to select, and you’ll see everything in between get selected.
    3. You’ll then get a menu of options like creating a highlight or a citation from that passage of text.

    OK, got it!

    Cited passage

    Style
    Citations are available only to our active members.
    Buy instant access to cite pages or passages in MLA 8, MLA 7, APA and Chicago citation styles.

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

    1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

    Cited passage

    Thanks for trying Questia!

    Please continue trying out our research tools, but please note, full functionality is available only to our active members.

    Your work will be lost once you leave this Web page.

    Buy instant access to save your work.

    Already a member? Log in now.

    Search by... Author
    Show... All Results Primary Sources Peer-reviewed

    Oops!

    An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.