We Should Care About the Costs of Inflation

by Breana Pennington

It was noted in lecture that we shouldn’t care about the costs of occasional, expected inflation because the negative effects of an increase in the overall price level of the economy are subtle. However, we should care about sustained, long-term inflation because one important effect can be an increase in unemployment. This is explained by Milton Friedman’s natural rate hypothesis, which is interpreted by Paul Krugman as occurring

…after a sustained period of inflation, people would build expectations of future inflation into their decisions, nullifying any positive effects of inflation on employment. For example, one reason inflation may lead to higher employment is that hiring more workers becomes profitable when prices rise faster than wages. But once workers understand that the purchasing power of their wages will be eroded by inflation, they will demand higher wage settlements in advance, so that wages keep up with prices. As a result, after inflation has gone on for a while, it will no longer deliver the original boost to employment. In fact, there will be a rise in unemployment if inflation falls short of expectations. [link]

Therefore, there is a short-term benefit of increases in wages (whether psychological or real) that are caused by inflation, but in the long-run expectations may change due to the likelihood of unemployment that is induced by inflation.

Additionally, sustained, unexpected inflation affects baseline investment. Arguably, investment decisions will be affected by inflation that occurs over a long period of time even if it is “unexpected.” Creditors would be harmed by the loss in purchasing power on the loan payments they receive. At the same time, the unexpected inflation would allow borrowers to have less of a burden in paying off their debts. As a result, optimism within the business community will rise after a sustained period of inflation. This will increase baseline investment in order to take advantage of the loans that have become less burdensome. Consequently, as baseline investment increases so too will the real interest rate. According to the flexible-price model, this change in the real interest rate will affect the equilibrium of the flow-of-funds and flow-of-output approaches, which allows potential output to equal actual output.

It is also worth noting that Friedman argues that only a high rate of growth in the money supply can lead to long-term, sustained inflation. Friedman summarized this idea when he stated that

…inflation is always and everywhere a monetary phenomenon. [link]

As a result, governments should not be blamed for sustained inflation because their policies, unlike the Federal Reserve, do not have long-term affects on the money supply. Therefore, the negative costs to politicians due to the belief by voters that inflation is a sign of government mismanagement are unwarranted.

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