Saturday, December 31, 2011

Costs of Inflation

I just read a great article, published by Slate here, about the role that money has in creating and  recessions.  Its a good overview of how money, for all of its benefits, also results in some issues.  I do not believe the Keynesian theory that inadequate "aggregate demand" results in recessions would exist in a barter economy.  Of course, a barter economy brings about so many transaction costs that any benefit from consistent aggregate demand would be dwarfed by these costs.

According to the Slate article, the solution is to eliminate paper money.  Requiring only electronic money would allow negative interest rates to exist.  I think its quite a thought, and do believe providing a mechanism for negative interest rates could be useful.  One of the less radical alternatives to a currency-less society mentioned in the article is to increase inflationary expectations.

The benefits of low--but some--inflation is not a new concept.  It led me to thinking about the costs of elevated inflation. After all, if inflation reduces the incentive to hold money, people will replace monetary holdings with investments and goods.  Interest rates on investments should factor inflationary expectations into the assets' yields, leaving the real yields unchanged.  So why is inflation bad?

Common cited costs of inflation include:
  • Menu costs:  Costs of changing prices listed online, in advertisements, and other materials (such as menus).
  • Shoe leather costs:  Costs of seeking the best prices as prices keep moving upward.  Not all prices move in in a coordinated manner.
  • Tax bracket implications:  Unexpected inflation can move taxpayers into higher tax brackets in a progressive tax system, without the taxpayer earning more in real terms.  As a result, additional wealth shifts from taxpayers to Uncle Sam.
  • Managerial time and attention:  When costs are changing, firms have to decide how often and by what amount prices should be updated.  This requires managerial decision making.
To me, these costs seem small unless serious inflation is underway.  If the inflation rate moves to around 10-15% annually, I don't see these costs as serious drawbacks of inflation.

I've thought about some other implications of inflation, two of which I describe below.  The first I've seen discussed many times.  The second, I have not seen raised.  To me, these seem more persuasive as real costs of moderate and elevated inflation.
  • Contracting difficulties:  The ability to contract allows firms and individuals to reduce risk and transaction costs. A negotiated long term contract is generally more efficient from a transaction cost perspective than repeated short term negotiations. The ability to contract in nominal terms facilitates economic activity.  Inflation makes nominal contracting difficult as the real contract value changes over time in an inflationary environment.
  • Real costs of capital increases:  Because many investors pay taxes, they are concerned with after-tax real returns on their investments. Taxes must be paid on nominal returns, however.  As a result, taxable investors must demand a larger pre-tax real return in an inflationary environment to achieve the same after-tax returns.  For example, consider two different scenarios.  In both scenarios, a taxable investor requires a 5% after-tax real return and the applicable tax rate for the investor is 50%.  In scenario 1, the inflation rate is 0.  In scenario 2, the inflation rate is 10%.  The investor would find an investment paying a pre-tax 10% nominal (and real) return acceptable in scenario 1, as it results in a 5% after tax real return.  In scenario 2, the investor would require a pre-tax 30% nominal return.  The after tax return nominal return is 15% (given the 50% tax rate), and the after-tax real return is thus ~ 5% (15% after tax nominally - 10% inflation rate).  Importantly, the real cost of capital to the firm in such an example is twice as much in scenario 1 as scenario 2.*  The firm's real cost of capital is equal to its nominal cost of 10% in scenario 1.   In scenario 2, the firm must pay a 20% real cost of capital (30% nominal -10% inflation).  Such an elevated real cost of capital is likely to reduce the capital stock and overall GDP in the economy.
I still think there are many other factors, not described above, that cause inflation to be harmful to our society.  With so much discussion in the financial media about inflation concerns and considerations, it is surprising to me that discussion of why inflation is such a concern is not addressed more often.  Any updates will be shared as I learn more on this topic...

*The cost of debt capital differs from the cost of equity capital in that debt capital is paid with pre-tax dollars.  This reduces the effects of inflation on debt capital transactions, provided both the issuer and investor are taxable entities and the applicable tax rate is same for both.  This difference between debt and equity capital costs is amplified in high inflationary environments and can thus distort the use of debt vs. equity capital in such environments.

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