Inflation
Why Does It Matter?

Conventional economic theory tells us that, since consumer and firm decisions depend on relative rather than absolute prices, a doubling of the money supply should leave the real side of an economy unchanged. It is therefore by no means clear why inflation, if fully anticipated, should be costly. However, there are reasons for believing that this view is oversimplified. First, economic theory tends to downplay the transactions role of money. Yet one cost of inflation may result from the rise of the (opportunity) cost of holding money for transactions purposes in inflationary times. This leads to people making an excessive number of trips to the bank (the 'shoe leather effect'), and encourages people to shift from financial assets to real capital (the Tobin effect). Second, conventional theory tends to ignore taxes -- but if the tax system is not indexed, it is clear that inflation will have real effects as, for example, workers move into higher income tax brackets.

Such views about the cost of inflation are by now well known. In a recent Discussion Paper, CEPR Research Fellow John Moore surveys some more recent ideas of the 'costs' imposed by inflation.

The 'price misperceptions' model of Lucas, Barro, and others is based on the idea that agents cannot distinguish between relative (real) shocks and absolute demand (nominal) shocks. This suggests that an increase in the variability of inflation due to an increase in the variability of the (unobserved) money supply can lead to inefficiencies in output and employment decisions -- with perhaps a concomitant increase in the variability of relative prices. An increase in the variability of relative shocks will also lead to inefficiencies. There have been a number of empirical studies which establish positive links between combinations of these variabilities. But Moore argues that many of these studies establish correlations between the wrong quantities. The theoretical predictions are also less clear-cut than is often supposed. Theory gives no reason to suppose that an increase in the average level of inflation should have welfare costs, or that there should be a relationship between the average level of inflation and the variability of inflation or relative prices. Nor, Moore argues, is it necessarily the case that greater price uncertainty leads to unambiguously lower welfare.

What other effects might inflation have? Sheshinski and Weiss note that changing prices may itself be costly - sales catalogues have to be updated. At higher rates of inflation then, when (monopolistic) firms do adjust their prices, they do so by greater percentages and out of phase from one another. The variance of relative prices in the economy thus increases.
Moore also outlines new work done jointly with Oliver Hart. Moore and Hart suppose consumers think in nominal, rather than real terms. There are two reasons why what consumers remember might be less informative when inflation is higher: (a) they may not have good recall of when they made their previous purchases; (b) they may have a form of 'bounded rationality', in that they are poor at calculating percentage increases. Firms can exploit this fuzziness in consumers' knowledge of price distributions in their pricing policies. All of the following are shown to rise with inflation: (i) the mean, variance, and width of the support of the distribution of prices; (ii) the amount of (costly) search which is done; and (iii) the total number of firms in the market (each incurring a fixed cost). From (ii) and (iii) it follows that the welfare effect is unambiguous: higher inflation imposes greater costs.

Inflation can cause problems for firms (and also consumers) if loan sizes remain unchanged. The liquidity of firms may be severely reduced as nominal interest rates rise ('front-end loading'). This can cause firms to cut back on both output and employment. Empirical work suggests that this may be the most important effect of inflation.

Why do loan sizes not increase under inflation to keep real indebtedness constant? Moore suggests that a model by Gale may provide a clue to this puzzle. Inflation may be related to business confidence in the following way. There is a conventional idea of how much it is safe to lend on certain types of security. If this amount is expressed in terms of money, then its real value will be reduced by inflation. There is no money illusion at work here: each bank, say, is behaving rationally, but since it must take the behaviour of other banks as given, it must also take the convention as given. When the 'real' convention changes, the 'nominal' convention staying the same, everyone's real behaviour must adjust. Inflation may have real consequences (costs) simply because agents believe it will.


The Costs of Inflation: Some Theoretical Issues
John Moore

Discussion Paper no.19 May 1984 (ATE)