Home > Macro, Money > Is zero inflation optimal?

Is zero inflation optimal?

Discussion on the ‘costs of inflation’ is a staple of A level Economics courses. You have probably heard these arguments before:

Shoe leather costs – as inflation rises and money becomes worth less, you have to take more trips to the bank so are wearing out your ‘shoe leather’ (really the cost here is the cost of your time rather than your shoes unless you are wearing really flimsy shoes).
Menu costs – as inflation rises and firms have to change their prices more often, they incur costs reprinting menus, catalogues etc.
Tax distortions – the classic case is ‘fiscal drag’ – governments usually set and fix tax bands at the start of the financial year, so if prices are rising sharply that has a distortionary effect, eg if higher rate income tax kicks in at £40000 a year, and you are earning £35000 a year in an environment where there is 20% inflation, your employer might give you a pay rise to keep pace with inflation putting you on £42000 – in real terms that is just the same as earning £35000 a year ago, but now you have suddenly become a ‘high rate’ tax payer. This also happens for capital gains tax, when people sell assets like houses that have appreciated in value due to high inflation, the tax paid becomes disproportionately high.

These answers will probably get you marks in an A level exam but in the modern economy these aren’t major issues unless you get into hyperinflation territory. There is so much electronic banking these days that shoe leather costs are minimised, and many businesses, especially in retail, change prices all the time anyway regardless of inflation, cycling offers and discounts to attract customers. Many do business on the internet as well where it’s easy to change your menus. So the menu costs are not massive. As for tax distortions they are a real nuisance but they could easily be dealt with if the government just changes their tax rules to be indexed to inflation. The fact they don’t is probably because the government is usually the one who benefits from fiscal drag anyway so they will just take the extra tax revenue (in an environment of high inflation they want to take all the benefits they can get).

Here are the big problems that come from inflation being high:

Money illusion – price signals break down when people lose their ability to judge and compare prices over time. This sounds like such a basic fact but it underpins the whole market economy. Lets say for example you decide to go shopping for some Levis jeans. Say last time you went looking for jeans was eight months ago, you saw Levis were around £80 so you will have this kind of idea in your mind as to the price of Levis. If we are in a low inflation environment (say 2%) and you see some Levis in a shop at £90 then you will have an instinctive feel for the fact that is probably pricey and you can get it elsewhere. If the market price was £80 eight months ago and inflation is 2% per year then that means that every month prices will be rising 1.02^\frac{1}{12}=1.00165 in other words they are rising 0.165% per month, so after eight months you would expect the market price to be 80(1.00165^8 )=81.06. This is basically a stable price, so your ‘feel’ for the market price as being £80 will be more or less right.

Now think of that scenario but in an environment where inflation is running at 60%. Say you see some jeans on offer for £105, is that a good deal or a bad deal. That is quite hard to do in your head – you have to make an ‘educated guess’ and you could be right or wrong.

If you actually had a calculator, and knew what you were doing in terms of compound interest, you could say that 60% inflation means 1.6^\frac{1}{12}=1.0399 ie prices are rising 3.99% per month, so after eight months you would expect the market price to be 80(1.0399^8 )=109.44. So in this case an offer of £105 is good, they are below the market price in real terms. But you aren’t going to do that in your head so you have lost the instinctive feel for prices.

This is what happens when inflation gets high, and the higher inflation is the more people lose their ability to compare prices, so it undermines the whole ability of firms to compete with each other on prices, and prices lose their ability to signal scarcity.

Inflation variability – generally low inflation means stable inflation and high inflation means variable inflation from one year to the next. Inflation in the UK (the RPI) from 1997 to 2005 was 3.3%, 2.4%, 2%, 2.7%, 1.3%, 2.9%, 2.6%, 3.2%, 2.4%. Compare this to the period between 1973 and 1981: 12%, 19.9%, 23.4%, 16.6%, 9.9%, 9.3%, 18.4%, 13%. Instead of varying by 1-2% per year, it is jumping around in variations of 5-10% per year. And this is the UK, which has traditionally been a low or medium inflation economy, the figures for some Latin American countries would dwarf that for variability. Variability is a problem because businesses need to plan for inflation when they set their wage levels, set their prices, sign contracts with suppliers etc. If you get it wrong by a percent or so its not too bad but if you think inflation will be 10% higher than it ends up being, and you have set your prices accordingly, you could be in for a big loss. The result is when inflation is high, firms do less investment and think more ‘short term’ rather than planning for the long term.

On the other hand there are some ways in which having some inflation is preferable to none.

Wage flexibility – generally wages are ‘sticky downwards’, which means that you very rarely get pay cuts in nominal terms, apart from in the more flexible parts of the private sector. Trying to cut workers’ wages in nominal terms stirs up a hornets nest of legal challenges and trade union action, so a pay freeze is about as strict as you usually get. Sometimes in a benevolent economic environment, especially when there is an unsustainable boom, wages can jump ahead of productivity, which means there will be problems down the line, not least in the context of international trade where a country with firms paying wages above its level of productivity will lose competitiveness to international competitors. So you need wages to adjust downwards, which is a slow and painful process – and the lower inflation is, the harder this is. You don’t actually need high inflation to carry out an adjustment, just a medium level. In the UK for instance, the government announced a three year public sector pay freeze in 2010. If inflation during that period runs at 4% then that means in real terms wages will fall by close to 12%, so that is an effective way of bringing wages back down in line with productivity. But if inflation was creeping around 1-2% it would take much longer to get the same adjustment.

Option of real negative interest rates – this is a big one when the economy is in trouble, particularly in the face of a liquidity trap. The issue here is that nominal interest rates can’t fall below 0%, but what influences investment is not nominal but real interest rates. As r \approx i - \pi. you can stimulate investment by pushing down real interest rates through higher inflation, when nominal interest rates are 0%, real interest rates can be - \pi. Again you don’t want to trigger hyperinflation in order to break out of a liquidity trap, but you might find inflation of 5-6% useful, rather than 1-2%.

Seignorage revenue -fraught with danger this one, because it can easily be misused and trigger an inflationary spiral. However for a developing country where it is difficult to collect taxes, seignorage revenue can be an important part of government revenue.

So what is the optimal level of inflation? There isn’t a set guide and it depends on opinion. By and large most Western democracies aim for low levels around about 1.5-2%. There are some that argue you should try to push inflation down to as close to 0% as possible, and there are others that argue some of the excessively tight monetary policy used to keep inflation low is counterproductive, and that there is nothing really wrong with inflation at 4-6%. Certainly the real negatives of inflation don’t kick in till you get higher rates (eg double figures).

The big danger with inflation though is its tendency to accelerate out of control, so once you get to 10%, it can quickly start to creep up towards 15-20% and beyond, where negatives do start to mount up.

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Categories: Macro, Money
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