Economic Commentary on the Costs of Inflation
3. A More Sophisticated Approach
In obtaining their estimates of the costs of inflation, Bailey and Fischer use the simple supply and demand analysis familiar to any student of elementary economics. More recent estimates of these costs have been obtained using more sophisticated models that are an outgrowth of real business cycle theory, which arose in the 1980s. The key feature of the real business cycle program is the adoption of a methodology in which economic phenomena are modeled by explicitly specifying the features of the basic microeconomic structure, such as preferences and technologies.
To explore the costs of inflation within a real business cycle model, we first need to specify why economic agents hold money. One way to do this is to adopt the cash-inadvance constraint, which states that individuals must have cash balances in their pocket at the start of the period in order to purchase goods. That is to say, these goods cannot be purchased on credit. Somewhat more flexible formulations allow money balances to help conserve on either shopping time or the pecuniary costs of making transactions. For the present purposes, these details are of secondary importance. It is sufficient that there is a well-defined "demand" for cash balances.
A feature that this class of models shares with some simpler frameworks is that increases in inflation can arise only through increases in the growth rate of money. When the rate of inflation rises, its proximate effect in these models is to distort the household's choice of how much to work. Owing to the cash-in-advance constraint, $1 earned today cannot be spent until tomorrow, when the price of goods will have risen. Consequently, the $1 earned today will garner fewer goods than it could purchase today. From the household's perspective, an increase in inflation acts in much the same way as an increase in the tax on its labor earnings; both serve to reduce the real wage received by the household. In the face of a fall in its real wage, we expect that the household will reduce the quantity of labor it is willing to supply. As a result of less labor, real production in the economy will fall.
A secondary channel through which inflation affects real activity operates via capital accumulation. Since households supply less labor, a given unit of capital is less productive in the sense that it produces less output (given the quantity of labor now being supplied). Since the return on capital has fallen, firms will curtail their investment activity in order to bring the return on capital in line with the long-run real interest rate, which is determined by the household's rate of time preference. (The "rate of time preference" is related to the real interest rate and refers to the idea that people prefer a unit of consumption received today over a unit received in the future). To summarize, the long-run response to higher inflation is lower employment, capital, and output.
Suppose that in the model just described, the rate of inflation increases from 0 percent to 10 percent. To evaluate the costs of inflation, we ask the following hypothetical question: How much consumption would the representative household be willing to forego in order to avoid living in the 10 percent inflation world? The answer gives us the welfare cost of 10 percent inflation relative to 0 percent inflation; this figure is typically expressed as a percentage of output.
Thomas Cooley and Gary Hansen were among the first to try to quantitatively assess the costs of inflation in an environment like the one outlined above. Relative to an optimal inflation rate (–4 percent per annum in their model), they found that an inflation rate of 10 percent resulted in a welfare cost of 0.4 percent of income. This figure is fairly typical of the estimates other researchers have subsequently obtained.
A slightly different way of casting the Cooley and Hansen result is to say that a reduction in the inflation rate from 10 percent to –4 percent would result in a 0.4 percent welfare gain. As with the simple supply and demand case, remember that this is a gain which can be enjoyed each and every year into the future.