曼昆第10版讲义mankiw10e-irm-ch05

|CHAPTER5: Inflation:ItsCauses,Effects,andSocialCosts

LectureNotes|

CHAPTER5

Inflation:ItsCauses,Effects,andSocialCosts

NotestotheInstructor

ChapterSummary

Thischapterexplainstheclassicaltheoryofthecauses,effects,andsocialcostsofinflation.Itintroducestopicsthatarecentralforunderstandingtheeconomyandpresentsconceptsusedelsewhereinthetextbook.Thesetopicsinclude

Howthesupplyofanddemandformoneydeterminetheaveragelevelofprices

Theeffectsofmonetarypolicywhenpricesareflexible

Thesocialcostsofinflation

ThematerialinthischapterbuildsuponthediscussionofmoneyandthemonetarysystempresentedinChapter4.

Comments

Thischaptercanprobablybecoveredintwolectures,althoughthematerialonhyperinflationisdifficultandsomayrequirealittleextratime.Sincehyperinflationsarebothfascinatingandinstructive,thispartofthechapterisultimatelyveryrewardingforthestudents.

TheFisherequationandthedistinctionbetweennominalandrealratesofinterestareamongthemostimportanttopicsinthechapter.Iemphasizethisasanoccasionwheremacroeconomicsprovidesanimportantinsightthatmanynoneconomistsdonotunderstand.IliketotellstudentsthatiftheyunderstandtheFisherequation,thentheyknowmoreeconomicsthanformerPresidentBushknows(orpretendstoknow?);seeSupplement16-9,“DistrustofPolicymakers.”

UseoftheWebsite

ThisisagoodtimetousethedataplottertoexplainandillustratetheFisherequation.

UseoftheEWebsite

GototheEwebsiteanddownloadannualdataforthepast40yearsforthetwokeymeasuresofthemoneysupply:M1andM2.AlsodownloaddataoverthesameperiodfornominalGDP.ComputetwomeasuresofthevelocityofmoneybydividingGDPbyeachofthetwomeasuresofthemoneysupply.Discusshowthevelocityofmoneyhaschangedovertimeforthesetwomeasures.

ChapterSupplements

Thischapterincludesthefollowingsupplements:

5-1 TheVelocityofMoneyinPoetryandSong

5-2 DataonMoneyGrowthandInflation(CaseStudy)

5-3 SeigniorageasanInflationTax

5-4 DerivingtheFisherEquation

5-5 UsingInterestRatestoForecastInflation(CaseStudy)

5-6 TransactionsModelsofMoneyDemand

5-7 HowCurrentandFutureMoneyAffectthePriceLevel

5-8 InflationandEconomicGrowth

5-9 TheWelfareCostsofInflationandtheOptimumQuantityofMoney

5-10 TheWelfareCostsofInflationRevisited

5-11 Indexation

5-12 U.S.TreasuryIssuesIndexedBonds

5-13 AGuidetoOz(CaseStudy)

5-14 AreMonetaryAllegoriesintheEyeoftheBeholder?TheCaseofMaryPoppins(CaseStudy)

5-15 HowtoStopaHyperinflation

5-16 TheIsraeliHyperinflation

5-17 AdditionalReadings

LectureNotes

Introduction

Sofar,ourentireanalysisoftheeconomyhasbeeninrealterms,sinceeconomiststhinkthatpeopleultimatelycareaboutgoodsandservices,notaboutthedollarvalueofthosegoodsandservices.Becauseofthisemphasis,wehaveignoredoneofthemainissuesofmacroeconomics—inflation—andwealsohavenotyetbeenabletodiscussmonetarypolicyindetail.

Overatleastthepast40yearsintheUnitedStates,priceshavetendedtorise.Thisdoesnotmeanthatthepriceofeverysinglegoodhasrisen;personalcomputers,forexample,aremuchcheapernowthantheywereafewyearsago.Butbyandlarge,andonaverage,goodscostmorenowthantheydidinthepast.Thisgeneralincreaseinthepriceofgoodsandservicesisknownasinflation.AsdiscussedinChapter2,economistsmeasureincreasesinthepricesofgoodsandservicesbyconstructingpriceindexes,whicharesimplyweightedaveragesofthepricesofdifferentgoods.Theweightsarebasedontherelativeimportanceofthegoodsinconsumption.

TherecentU.S.experiencehasbeenoneofmoderatebutpositiveinflation.Inrecentyears,priceshavebeenrisingbyaround2.5percentperyearonaverage,whiletheaveragerateofinflationwassomewhathigherinthe1970sandearly1980sandslightlylowerinthe1950sand1960s.Butthisisnottheexperienceofallcountriesatalltimes.Earlierinthiscentury,theUnitedStatesexperiencedperiodsofdeflation—fallingprices.Othercountrieshaveexperiencedhyperinflations—veryrapidlyrisingprices(hundredsofpercentpermonth).

Peopleapparentlydislikeinflation.ThehighinflationattheendoftheCarterpresidencywasoneofthereasonsReagandefeatedCarterinthe1980presidentialelection.TheFederalReserveBoarddirectsmuchofitspolicymakingatcontrollinginflation.Policymakerswatchinflationcarefully.Iffornootherreasonsthanthese,weneedtounderstanditscausesandeffects.

Itisimportanttounderstandthedistinctionbetweenthepricelevelandtheinflationrate.ThepricelevelisessentiallythedollarcostofoneunitofGDP.Theinflationratemeasuresthegrowthrateofthepricelevel.Whenpricesarerising,thismeansthattheinflationrateispositive.Whenpricesarefalling,theinflationrateisnegative.Itispossibleforpricestoberisingbutfortheinflationratetobefalling.Forexample,supposethatP90=1,P91=1.2,andP92=1.32.Here,apizzathatcost$10in1990wouldcost$12in1991and$13.20in1992.Goodsarebecomingmoreexpensiveovertime,butpricesincreasedmorebetween1990and1991(20percent)thanbetween1991and1992(10percent).Thissituation,inwhichpricesarerisingbuttherateofinflationisfalling,isknownasdisinflation.

SincethepricelevelisthecostindollarsofaunitofGDP,itcanalsobethoughtofasameasureofthepriceofmoney:oneunitofGDPwillbuy1/Pdollars.Tounderstandthepricelevel,andhencetheinflationrate,wemust,therefore,understandtherelationshipbetweenmoneydemand,moneysupply,andthepricelevel.

5-1 TheQuantityTheoryofMoney

TransactionsandtheQuantityEquation

Havingbrieflyconsideredthesupplyofmoney,wenowturntothedemandformoney.Webeginwithaverysimpletheoryofmoneydemand,knownasthequantitytheory.Thestartingpointforthistheoryistheobservationthatpeopleholdmoneylargelytofacilitatetransactions.SupposethatTtransactions(exchangesofgoodsformoney)takeplaceinayearandsupposethatPisthepriceinatypicaltransaction.Then,thenumberofdollarsexchangedinayear,bythedefinitionofthesetwovariables,equalsPT.

Sincemoneychangeshandsinthesetransactions,wecanusethisinformationtoinferthenumberoftimesthatthetypicaldollarbillchangeshandsduringtheyear.IfweletVTbethenumberoftimesthatadollarbillchangeshands,andweletMbethemoneysupply,thenthenumberofdollarsexchangedinayearmustalsoequalMVT.Thus,wehavethequantityequation

MVT=PT.

Thisequationisanidentity;itmustbetruebythedefinitionofthevariables.ThenumberVTisthetransactionsvelocityofmoney.

FromTransactionstoIncome

SupposethateachtransactionrepresentsoneunitofGDP.Thiswouldbetrueiftheonlytransactionsthattookplacewerethosethatinvolvedthefinalsaleofnewlyproducedgoods.Then,wecouldreplaceTwithYandgetanamendedformofthequantityequation:

MVT=PY.

Inreality,ofcourse,notalltransactionsrepresentthesaleoffinalproducedgoods.Thesaleofausedtextbook,forexample,isatransactionthatdoesn’thaveanythingtodowithGDP.Butwemightwellbelievethatthereisafairlycloserelationshipbetweenthenumberoftransactionsandfinaloutput.Basedonthisidea,wedefinetheincomevelocityofmoneyas

IfYisproportionaltoT,theincomevelocityofmoneywillbeproportionaltothetransactionsvelocity.Forexample,iftherearethreetransactionsforeverytransactioninvolvingaunitofGDP,thenthetransactionsvelocityofmoneyisthreetimestheincomevelocityofmoney.

Supplement5-1,“TheVelocityofMoneyinPoetryandSong”

Theadvantageoftheincomevelocityofmoneyisthatwecaneasilymeasureit;itissimplynominalGDPdividedbythemoneysupply.IfweperformthiscalculationandfindthatV=4,andifwethinkthatthenumberoftransactionsisthreetimesthenumberoftransactionsforfinalgoods,theneachdollarbillwouldchangehands12timesonaverageduringtheyear.

TheMoneyDemandFunctionandtheQuantityEquation

Asimpleideaaboutmoneydemandisthatpeopleholdmoneytocarryouttransactions,andtheamountofmoneytheywanttoholdisroughlyproportionaltothenumberoftransactionstheywanttoperform.Ifthenumberoftransactionsis,inturn,proportionaltoincome,thentheamountofmoneythatpeoplewanttoholdisproportionaltoincome.Also,wemightexpectthattheamountofmoneythatpeoplewanttoholdwillbeproportionaltothepriceofatransaction;ifthecostoftheaveragetransactiondoubles,thenwewouldexpectthatthedemandformoneywoulddouble.Thisleadstoamoneydemandfunctionoftheform

Md=kPY.

Aselsewhere,weprefertocarryoutouranalysisinrealterms.ThetermM/Piscalledrealmoneybalances;ittellsusthevalueofMintermsofgoods.Sowecanrewriteourmoneydemandfunctioninrealtermsas

(M/P)d=kY.

Rememberthatthedemandformoneyisreallyademandfortheservicesthatmoneyperforms.Peopledon’twantmoneyforitsownsake;theywantitbecauseitsimplifiestransactions.Wegenerallyworkintermsofrealmoneydemand.

Noticethatthismoneydemandequationbearssomeresemblancetothequantityequation.Infact,theyareequivalentwithasuitableinterpretationofVandanassumptionofequilibriuminthemarketformoney.Ifthesupplyofmoneyequalsthedemandformoney,thenwehave

M/P=kY,

whichisequivalenttothequantityequationwithV=1/k.

TheAssumptionofConstantVelocity

Thequantityequation,therefore,becomesatheoryofthedemandformoneybysupposingthatmoneydemandisproportionaltooutput.Thismeans,inessence,thatweareassumingthatthevelocityofmoneyisconstant.Theassumptionofconstantvelocityisnotfullysatisfactory,forreasonsthatwewillcometo,butitisausefulstartingpoint.Note,moreover,wherethistheoryleadsus.IfVisfixed(V),thennominalGDPmustbeproportionaltothemoneysupply.IfYisalsofixed,thenthepricelevelisproportionaltothemoneysupply.

Money,Prices,andInflation

Letusexplorethisalittlefurther.Writingthequantityequationintermsofgrowthratesgives

∆M/M+∆V/V=∆P/P+∆Y/Y.

Lettingπ=∆P/Pandµ=∆M/M,andsupposingthatvelocityisconstant(so∆V=0),weobtainatheoryofinflation

π=µ–∆Y/Y.

AswewillseeinChapters8and9,thegrowthofoutputdependsonexogenousfactorssuchaspopulationgrowthandtechnicalprogress.Itfollowsthattheinflationratedependsonthegrowthrateofthemoneysupply.IftheFedkeepsthemoneysupplystable,priceswillbestable.Toputitanotherway,iftheFedwishestheinflationratetobezero,itshouldincreasethemoneysupplyatarateequaltothatofoutputgrowth.Inthatcase,therewouldbejustenoughextramoneyeachyeartoabsorbtheextrademandduetoextratransactions.

Figures5-1,5-2

Supplement5-2,“DataonMoneyGrowthandInflation”

CaseStudy:InflationandMoneyGrowth

DatafortheU.S.economysince1870providebroadsupportforthelinkbetweenmoneygrowthandinflation.DecadalaveragesoverthisperiodrevealapositiverelationshipbetweentheGDPdeflatorandthegrowthofM2.Internationaldatashowthecorrelationevenmoreclearly.

5-2 Seigniorage:TheRevenuefromPrintingMoney

Supplement5-3,“SeigniorageasanInflationTax”

ThediscussionofthecircularflowofincomeinChapter3revealedthatthegovernmentdeficitequalsthedifferencebetweengovernmentspendingandgovernmentincomefromtaxation.Thegovernmentcanfinanceitsdeficitbyborrowingfromthepublicorbyprintingmoney.Newmoneyisasourceofgovernmentrevenue,liketaxation.Therevenuethatthegovernmentobtainsbyprintingmoneyisknownasseigniorage.

Whilethegovernmentcanprintmoneyandusethatmoneytopurchasegoodsandservices,itobviouslydoesnotgetthesegoodsandservicesforfree.Someoneispayingforthem.Ineffect,whenthegovernmentprintsnewmoney,itleviesaninflationtax.Asmoremoneyisintroducedintotheeconomy,wenowknowthattherewillbeinflation.Anincreaseinthemoneysupplyincreasesthegeneralpricelevel.Thismakesexistingmoneyintheeconomyworthless;existingmoneyholdingsdeclineinrealvalue.Inflationservesasataxonrealbalances.

SeigniorageisnotanimportantsourceofrevenueintheUnitedStates,butithasbeenusedtofinanceasignificantfractionofgovernmentspendinginsomeothercountries.Wereturntothiswhenwediscusshyperinflation.

CaseStudy:PayingfortheAmericanRevolution

TheContinentalCongressdependedsignificantlyonseignioragetofinancetheRevolution.Newissuesofcontinentalcurrencygrewapproximately20-foldbetween1775and1779,leadinginturntosubstantialinflation.

5-3 InflationandInterestRates

TwoInterestRates:RealandNominal

Wenowturntothedistinctionbetweennominalandrealinterestrates.Thisisanoccasionwhenmacroeconomicsteachesanimportantandsimple,yetoftenoverlooked,insight.Theinterestratequotedinthenewspapersisanominalinterestrate.Itgivesthenumberofdollarsthatwillbepaidnextyearforadollardepositedtoday.Forexample,a10percentinterestrateimpliesthat$100depositedtodayearns$110nextyear.Butsupposethatpricesalsoriseat10percentperyear.Then,$100depositedinthebankhasexactlythesamepurchasingpowerintermsofrealgoodsnextyearasthisyear.

Thedollarpriceofgoodsisnotultimatelyimportanttopeoplemakingeconomicdecisions;rather,theycareaboutrealtradeoffs.Anindividualdecidingwhethertoconsumetodayortosaveforconsumptionnextyearneedstoknowhowmuchshecangetintermsofgoodsnextyearifshegivesupgoodstoday.Inotherwords,shecaresabouttherealinterestrate.Therealinterestratecorrectsforinflation.Intheprecedingexample,therealinterestratewaszero,eventhoughthenominalratewas10percent.Thissuggeststhattheequationfortherealinterestrateis

Supplement5-4,“DerivingtheFisherEquation”

r=i–π.

Rememberthattherealinterestrateistheinterestratethatmattersforinvestment.Firmsmakeinvestmentdecisionsbyweighingthefuturebenefitsofsomeinvestmentproject(say,buyinganewmachine)againstthecost.Thiscalculationismadeinrealterms.Ifinflationishigherbutnominalinterestratesarealsohigher,thenthefirmwillhavetopaybackmoreindollartermsforitsloan,butwillequallygetmoreindollartermsforthegoodsitsells.

TheFisherEffect

Byrearrangingtheequationfortherealinterestrate,wefindthatthenominalinterestrateisequaltotherealinterestrateplusinflation:

i=r+π.

Noticethatwenowhavetwoimplicationsofanincreaseinthemoneygrowthrate.First,ourtheorypredictsthatanincreaseinthemoneygrowthrateof,say,1percentshouldincreasetheinflationrateby1percent.Inturn,thisshouldimplya1percentincreaseinthenominalinterestrate.ThislinkbetweentheinflationrateandthenominalinterestrateisknownastheFishereffect.

CaseStudy:InflationandNominalInterestRates

Figures5-3,5-4

Supplement5-5,“UsingInterestRatestoForecastInflation”

ThedatafortheUnitedStatesandothereconomiesclearlyrevealtheconnectionbetweentheinflationrateandthenominalinterestratesuggestedbytheFishereffect.

TwoRealInterestRates:ExAnteandExPost

Thepreviousdiscussionismisleadinginonerespect.Whenpeoplemakeintertemporaleconomicdecisions,theydon’tknowforsurewhattheinflationratewillbe.Thismeansthat,ratherthanusetheactualinflationrate,weshouldusetheexpectedinflationrate.Therelevantrealinterestrateforinvestors’decisionsisdefinedas

r=i–Eπ,

whereEπistheexpectedinflationrate.Thisisknownasanexanterealinterestrate;thepreviousdefinitiongivestheexpostrealinterestrate.AccountingforexpectedinflationimpliesthattheFishereffectismoreaccuratelydescribedby

i=r+Eπ.

Thisequationsuggeststhatthenominalinterestrateshouldberelatedtoexpectedinflation,notactualinflation.Butasmentionedearlier,thedatashowastrongcorrelationbetweenthenominalinterestrateandactualinflation.Thereasonisthatinflationisusuallyverypersistentandsoexpectedinflationissimilartoactualinflation.Indeed,theFishereffectisnotevidentinU.S.dataduringthelatenineteenthandearlytwentiethcenturies,whichwereyearswhentheinflationratewashighlyvariableandnoteasytopredict.TheabsenceofaFishereffectisprobablyduetodifferencesbetweenactualandexpectedinflation—thatis,betweenexanteandexpostrealinterestrates.

5-4 TheNominalInterestRateandtheDemandforMoney

Ourearlierdiscussionofmoneydemandnotedthatonefunctionofmoneyisthatitservesasastoreofvalue.Intimesofinflation,itserveslesswellinthisrole.Ifpricesarerising,adollarbillbuyslessandlessastimegoesby.Thissuggeststhatourpreviousanalysisofthedemandformoney,wheremoneydemanddependsonlyonincome,isincomplete.

TheCostofHoldingMoney

Theobservationthatinflationreducesthevalueofmoneysuggeststhat,iftheinflationrateishigh,peoplewillbelessinclinedtoholdtheirwealthintheformofmoney.Thisintuitionisbasicallycorrectbutnotcomplete.Itturnsoutthatmoneydemanddependsonthenominalinterestrateand,hence,indirectly(throughtheFishereffect)ontheinflationrate.

Supplement5-6,“TransactionsModelsofMoneyDemand”

Toseethis,notethatmoneyissimplyonewayinwhichpeoplecanholdwealth.Theadvantageofmoneyisthatitisconvenientfortransactions.Butithasanassociateddisadvantage:ifanindividualholdswealthintheformofmoney,shegivesuptheinterestshecouldearnifsheinsteadputherwealthintointerest-bearingassets.Theinterestthatshecouldhaveearnedbutdidn’tisanopportunitycost.Aninterest-bearingassetpaysaninterestrateofi;moneypayszerointerest.Thegreaterthedifferencebetweenthereturnonthesetwoassets,themoreindividualswanttoeconomizeontheirholdingsofcash.Thus,thedemandformoneydependsnegativelyonthenominalinterestrate.

Suchaconclusionmightseemcontrarytotheprinciplethatpeoplecareaboutreal,notnominal,values,butthisisactuallynotthecase.Therealreturnon,say,asavingsaccountistherealrateofinterest.Theexpectedrealreturnonmoneyisminustheexpectedinflationrate(–Eπ).Comparingtherealreturnonmoneyandinterest-bearingassetsagainrevealsthatthedifferencebetweenthetwoisthenominalinterestrate.Thus,whileinvestment(andperhapsconsumption)dependsontherealrateofinterest,moneydemanddependsonthenominalrateofinterest.Thissuggestsamoregeneralspecificationofmoneydemand:

(M/P)d=L(i,Y)=L(r+Eπ,Y).

FutureMoneyandCurrentPrices

Figure5-5

Supplement5-7,“HowCurrentandFutureMoneyAffectthePriceLevel”

Wehavenowmadelife,oratleastourtheory,morecomplicated.Supposethatweseea1percentincreaseinthegrowthrateofthemoneysupply.Thiswillincreasetheinflationrate.ButthroughtheFishereffect,thiswill,inturn,increasethenominalinterestrateandsodecreasethedemandformoney.Sowhenthegrowthrateofmoneyincreases,wegettheratherparadoxicalconclusionthattheamountofrealmoneyheldactuallygoesdown.

Thismorecompletetheoryofmoneydemandalsoimpliesthatthecurrentpriceleveldependsnotjustonthecurrentmoneysupplybutalsoontheexpectedinflationrate—henceontheexpectedfuturepricelevel,andhenceonthefuturemoneysupply.

5-5 TheSocialCostsofInflation

TheLayman’sViewandtheClassicalResponse

Supplement5-8,“InflationandEconomicGrowth”

Thegeneralpublicviewsinflationasamajorsocialproblembecauseofthemistakenbeliefthatrisingpricesmakeapersonpoorer.Thisnotionreflectsalackofunderstandingabouthowaproportionatechangeinallwagesandprices—overallinflation—isequivalenttoasimplerenumberingintheyardstickbywhichwemeasureprices,withnoeffectsonrelativepricesorrelativewages.Buteconomistshaveidentifiedsomesubtlecostsofmoderateinflation,althoughtheydisagreeaboutthesizeofthesecosts.

CaseStudy:WhatEconomistsandthePublicSayAboutInflation

TheeconomistRobertShillerusedasurveytoexaminetheattitudesofeconomistsandthegeneralpublicwithrespecttoinflation.Hediscoveredthatthepublicwasmoreinflationaversethaneconomists.Thisresultcouldbeduetothepublic’sbeliefthatinflationerodestheirrealpurchasingpower,abeliefsharedbyfeweconomists.Thepublicalsoseemstosufferfrommoneyillusion,preferringanincreaseinwageswithequalincreasesinpricesratherthanaconstantnominalwagecombinedwithstableprices.

TheCostsofExpectedInflation

Inconsideringthesocialcostsofinflation,ausefulstartingpointisthedistinctionbetweenanticipatedandunanticipatedinflation.First,considerthosecostsofinflationthatexistwhenallpricesandwagesarerisingatsomesteady,well-understoodrate.

Supplement5-9,“TheWelfareCostsofInflationandtheOptimumQuantityofMoney”

Thefirstsocialcostofinflationisshoe-leathercosts.Rememberthatthedemandformoneydependsnegativelyonthenominalinterestrateand,hence,ontheinflationrate.Whentheinterestrateishigh,itisworthwhileforpeopletoputsometimeandeffortintoeconomizingontheirholdingsofcash;theygotothebankmoreoftenand,metaphorically,wearouttheirshoesmorequickly.

Supplement5-10,“TheWelfareCostsofInflationRevisited”

Asecondcostofsteady,anticipatedinflationisalsoreferredtoinmetaphoricalterms:menucosts.Theideahereisthat,intimesofinflation,restaurantshavetoprintnewmenuswithchangedprices.Moregenerally,theactofchangingpricesmayabsorbrealresourcesintheeconomy.Whilethiscostisundoubtedlyreal,itseemsunlikelythatitissubstantial.

Athirdcostofinflationarisesbecauseitmayintroduceunwantedvariationinrelativeprices.Consideracatalogfirmthatchangesitspriceseveryyearbecauseofthecostofprintingitscatalog,andsupposethatotherfirmschangetheirpricesmorefrequently.Overthecourseoftheyear,ifotherfirmsincreasetheirprices,therelativepriceofthecatalogfirm’soutputwillfall.Microeconomicsstressestheroleofrelativepricesinensuringtheefficientallocationofresources.Totheextentthatinflationleadstoinfrequentpricechangesand,hence,todistortionsinrelativeprices,thepoweroffreemarketsisbeingrestricted.Partofthismisallocationalsomustbeunderstoodasthefactthattheinformationalcontentofpricesgoesdown.

Supplement5-11,“Indexation”

Afourthcostofinflationarisesfromthefactthatthetaxsystemisnotfullyindexedtotheinflationrate.Otherthingsequal,changesintheinflationratemaythusleadtodistortionsinthetaxsystem.Asanexample,taxbracketsusedtobe(andstillareinmanycountries)setinnominalterms;beyondsomedollarincome,themarginaltaxrateincreases.Ifwagesandpricesarerisingatarateof5percentperyear,thenmoreandmorepeoplewillfindthemselvesinthistaxbracketeveniftheirrealincomedoesnotincrease.TheTaxReformActof1986introducedmuchmoreindexingintothetaxsystem.Currently,capitalgainsandinterestincomearestilltaxedinnominalterms.

Recallthatonefunctionofmoneyisasaunitofaccount.Afifthcostofanticipatedinflationisthatitinterfereswiththisfunctionofmoney.Money,asaunitofaccount,servesafunctionanalogoustothatofotherunitsofmeasurement—themile,thegallon,etc.Inflationthenislikeasituationwherethemilechangesinlengtheveryyear.

AnotheraspectofthiswasmentionedbytheeconomistArthurOkun.Henotedthat,whencomparisonshopping,inflationmeansthatyouhavetoretainmoreinformation.Insteadofjusthavingtorememberwhereyousawagoodandatwhatprice,youalsohavetorememberwhenyousawit.

TheCostsofUnexpectedInflation

Unanticipatedinflationintroducesextrauncertaintyintotheeconomicenvironment.Generally,wethinkthatpeopledislikeuncertainty;ineconomists’terminology,theyareriskaverse.Thus,unanticipatedinflationhurtspeoplebecauseitleadstoarbitraryandunpredictableredistributions.Considertwopeoplewhoenterintoacontractspecifiedinnominalterms.Ifinflationishigherthanpredicted,thenthedebtor“wins”—shepayslessinrealtermsthansheexpected—andthecreditorlosessince,hegetslessinrealtermsthanheexpected.

Supplement5-12,“U.S.TreasuryIssuesIndexedBonds”

Fromasocialpointofview,suchredistributionsarenotthemselvesnecessarilycostly,butitisimportanttorecognizethattheydooccur.Furthermore,ifincreaseduncertaintydiscouragespeoplefromenteringintoeconomiccontracts,itisclearlycostlytotheeconomy.Inlightofthisobservation,economistsaresomewhatpuzzledbythefactthatpeoplewritemostoftheircontractsinnominalterms.Ifpeoplecaredaboutrealquantities,theycouldwritecontractsinrealterms—inotherwords,indexedtothepricelevel.Someindexingdoesexist,asforexampleincertainwagecontracts,butitislimitedinscopeandgenerallyincomplete.Perhaps,theconclusiontobedrawnisthatthisuncertaintyisnotperceivedtobeamajorcostofinflationbythosewritingsuchcontracts.

Onereasonthatpeopledislikeinflationhasnotyetbeenmentioned;itisanargumentwithwhichmosteconomistsaresomewhatuncomfortable.Itmaybethatpeoplearenotasrationalasweliketobelieve.Theymayfailtoseetheconnectionbetweenrisingwagesandrisingprices.Peoplemaybelievethattheyhaveearnedtheirwageincreasesandthenarebeingrobbedoftheseincreasesbyinflation.

Finally,forreasonsthatarenotfullyunderstood,highlevelsofinflationseemtobeassociatedinpracticewithhighlyvariableinflation.

CaseStudy:TheFreeSilverMovement,theElectionof1896,andtheWizardofOz

Supplement