The maintenance of low inflation rates has been given high priority throughout the world in the 1980s, with considerable costs in terms of lost output and high unemployment in OECD countries, and heavy debt service burdens elsewhere. Popular perceptions of the costs of inflation are usually associated with uncertainty about inflation or greater variability in relative prices, which may interfere with the efficient allocation of resources; yet economists have devoted relatively little attention to analysing these costs. In Discussion Paper No. 293, Research Fellows John Driffill, Grayham Mizon and Alistair Ulph review recent theoretical and empirical work on the costs of inflation.

Driffill, Mizon and Ulph survey recent models in which inflation is assumed to be stochastic and associated with variations in relative prices across industries and over time. Welfare costs of inflation can arise in such models from four sources. The presence of imperfect information may cause output in individual markets to depend on aggregate money shocks, rather than simply on relative demand shocks. Second, if agents cannot forecast future values of relevant variables perfectly, and have to make capacity decisions in advance, they may make different decisions from those they would make with perfect foresight. Third, if workers have to make a nominal wage decision before knowing the prices of consumption goods, and then have to supply whatever quantity of labour is demanded when goods prices become known, it appears that increasing the variability of real wages reduces the efficiency of production. Finally, there may be costs associated directly with the adjustment of prices itself. Such explanations come closer to modelling the popular perception of inflation as a source of uncertainty about relative prices, which leads to time lost searching for bargains and to unexpected redistributions of income and welfare; but they fall far short of rationalizing substantial welfare costs, according to the authors.
Driffill et al. also examine empirical estimates of the welfare costs of inflation, using data for the United States, the United Kingdom and some other industrial economies. They focus on the relations between the rate of inflation, its variance, its unpredictability, and the variability of relative prices. They argue that previous analyses have typically been based on a `confirmationist' econometric methodology, and have failed to treat inflation as an endogenous variable. The evidence of an association between the level of inflation and its variability is weak. In addition, much of the evidence of a relationship between the level of inflation and relative price variability is highly questionable: the authors present empirical results, using data for the UK, which show the fragility of earlier results for this relationship, obtained from confirmationist models. The authors also find no evidence to support a systematic relationship between unanticipated inflation and either relative price variability or the level of inflation. They conclude that although there is now a body of theoretical literature which links inflation to inflation variability and uncertainty, there remains a wide gap between formal theory and popular perception, and that the empirical links are not well established.

Costs of Inflation
John Driffill, Grayham E Mizon and Alistair Ulph

Discussion Paper No. 293, March 1989 (IM)