Costs of inflation and deflation
Moderate, predictable inflation causes few problems. High, volatile inflation and persistent deflation can both damage economies.
Shoe-leather and menu costs
When inflation is high, people hold less cash and make more trips to the bank, wasting time and effort (shoe-leather costs). Firms must change prices more often, reprinting menus and price lists (menu costs). These are small at low inflation but significant at high inflation.
Redistribution between borrowers and lenders
Unexpected inflation helps borrowers and hurts lenders, because loans are repaid with money worth less than expected. People on fixed incomes, such as some pensioners, lose purchasing power. Expected inflation is built into interest rates, so it redistributes less.
The Fisher equation
The real interest rate is approximately the nominal interest rate minus expected inflation: \(r \approx i - \pi^e\). A loan at 7% when inflation is 3% has a real rate of about 4%. If inflation unexpectedly rises to 6%, the lender's real return falls to about 1%.
Uncertainty and relative prices
High and volatile inflation makes planning hard, discouraging long-term investment and contracts. It also blurs price signals: firms struggle to tell whether their own price rise reflects higher demand for their product or general inflation, leading to poor decisions.
Inflation and taxes
Tax systems are often not fully indexed to inflation. Taxes on nominal capital gains can tax gains that are purely inflation. 'Bracket creep' pushes people into higher tax brackets as nominal incomes rise, unless thresholds are adjusted.
Why deflation is dangerous
Deflation can be harmful too. If people expect prices to fall, they may delay purchases, reducing demand. Debts become harder to repay because their real value rises (debt deflation), leading to defaults. Japan experienced years of mild deflation and slow growth from the 1990s, and the US saw severe deflation in the Great Depression.
Why central banks target about 2%
Many central banks, including the Federal Reserve, the European Central Bank, and the Bank of England, target inflation of about 2%. A small positive rate gives a buffer against deflation, allows real wages to adjust without nominal cuts, and accounts for measurement bias, while being low enough to avoid most costs of inflation.
Worked example
A homeowner borrows 200,000 dollars at a fixed 4% interest rate, expecting 2% inflation. Inflation turns out to be 5% for several years. The real interest rate is about -1%: the borrower gains, because the debt's real value shrinks, and the lender loses.
Key takeaways
Inflation causes shoe-leather and menu costs. Unexpected inflation helps borrowers and hurts lenders and fixed-income earners. The real interest rate is roughly nominal minus expected inflation. Volatile inflation creates uncertainty and blurs price signals. Unindexed taxes interact badly with inflation. Deflation can depress spending and raise real debt burdens. Many central banks target about 2%.
Flashcard
Effort of holding less cash
Check your understanding
A saver earns 3% interest while inflation is 5%. What is the approximate real interest rate?