The Costs of Inflation

Suppose we multiplied all dollar amounts in the economy by 100. Slap a couple 0s onto the end of your paycheck and bank account, erase the decimal point from all the price tags, do some hasty Sharpie work with the bills in your wallet… This would make everything nominally 100 times as expensive, and there would be 100 times as many dollars in the economy, but it wouldn’t really change much at all. It would be like if we all just agreed to start measuring things in cents instead of dollars.

In the real world, inflation can be harmful for the following reasons:

• Inflation acts as a tax on people who hold onto money.
• Inflation can cause relative prices to fluctuate as the economy adjusts.
  • This is especially problematic when talking about the real wage, which is the relative price of labor.
• People have to waste real resources responding to inflation.
  • Menu Costs are the resources firms spend to update their prices. This includes literally reprinting menus, but also things like redoing market and figuring out what the new prices should be.
  • Shoe-leather Costs are the resources wasted when people try to avoid holding onto money. As in, “you’ll wear out your shoes going to the bank.” These are typically small nowadays, especially with modern payment technology, but in periods of hyperinflation, shoe-leather costs can be rather dramatic.
• Agreements about future payments are often expressed in nominal terms. So unexpectedly high inflation can result in:
  • Unintentionally higher taxes on savings and capital gains.
  • Higher-than-expected real interest rates, which results in a transfer of wealth from lenders to borrowers.

¶ Inflation and Savings

¶ Unexpected Inflation Transfers Wealth

The Fisher equation says that

We can interpret this “ex-ante” as saying that the nominal interest rate is a combination of expected $\color{blue}\text{real interest rate}$ and the expected inflation rate. If I borrow money from you, the extra I promise to pay back reflects compensation for two things: you want to be rewarded with increased purchasing power, and by the time I pay you back, the money will be worth less.

But we can also flip things around and interpret the “ex-post” real interest rate as telling us the interest left over after accounting for inflation.

If inflation is stable and predictable, we get the same numbers either way. But if actual inflation is higher than expected inflation, then real interest rates will be lower than expected as well. This means:

• If inflation is higher than expected:
  • Borrowers will pay back less than they expected, in real terms.
  • They’ll pay back the expected amount of dollars, but those dollars will represent fewer resources.
  • This effectively results in a transfer from lenders to borrowers.
• If inflation is lower than expected:
  • Borrowers will pay back more than they expected, in real terms.
  • This effectively results in a transfer from borrowers to lenders.

¶ Inflation Taxes Savers

Even when inflation is predictable, high inflation rates still penalizes people who save their money, regardless of whether it’s in the form of cash, stocks, or bonds.

When you earn interest from a savings account or a bond, the nominal interest counts as income for the sake of taxes (with some exceptions). The decreases the after-tax real returns.

Likewise, with a nominal capital gains tax, if you buy a stock and its value goes up when you sell it, then you’ll be taxed even though your real wealth didn’t increase.

(And of course, if you save your money by keeping it as cash, you’ll be hit by inflation worst of all.)