CHAPTER: MONEY GROWTH AND INFLATION
One benefit of studying economics is that it gives you insight into world around you. The purpose of this chapter is to expand your understanding of inflation—a topic you will often see discussed in the news.
One of the biggest surprises about inflation is that it is not so obvious why it is a problem.
At first glance, you might describe inflation as getting less for your money. This is bad, at least if you only consider the buyer’s perspective. But think about the seller. He or she will get more money for whatever is being sold. So high prices are not, in themselves, a problem for society.
But economists have identified several real costs of inflation.
Monetary economists have traditionally emphasized the cost of people holding too little money, what they call the shoe-leather costs of inflation. In low-inflation economies, these costs are small, but not trivial. Economist Stanley Fischer estimated the shoe-leather costs of a steady ten percent inflation at about three-tenths of a percent of GDP. A tiny percentage, but it would amount to about 30 billion dollars a year today.
“Menu costs” are another cost of inflation. These include the costs that firms incur to change their prices, such as the costs of printing new menus, or paying workers to post new price tags. To gauge the importance of menu costs, economists have studied detailed data from national supermarket and pharmacy chains. In our low-inflation economy, these menu costs amount to under one percent of the typical store’s revenues.
Some economists have emphasized that, when the tax system does not take inflation into account, inflation can distort the tax system, which in turn distorts the economy. This cost of inflation is potentially quite large.
For example, under our tax system, people are taxed on their nominal capital gains, rather than the real capital gains they might earn. Other things equal, higher inflation leads to higher nominal gains, and that means a bigger tax bill. Thus, inflation raises the tax burden on capital, and this discourages investment and growth.
Finally, high inflation adds uncertainty to the real cost of borrowing, and the real return on saving. This hinders the ability of the financial system to get funds from households who are saving to firms with worthwhile investment projects.
As a general matter, economists have not reached a consensus about how large the costs of inflation are, at least for the moderate inflation that the United States has experienced in recent years. Yet most agree that the costs of inflation are substantial when inflation is high—more than 10 percent per year. And they are gigantic when an economy slips into hyperinflation.
When inflation is high, firms must change their prices more often, so menu costs become larger. Capital gains appear larger, and this raises the tax burden on capital. Even the shoe leather costs of inflation can be phenomenal, as you can learn by reading in your textbook about Mr. Miranda’s experience. This is a vivid example from Bolivia’s hyperinflation. I am sure you will conclude that this is not an experience that any country would want to repeat.