Economic Commentary on the Costs of Inflation

Read this article, which discusses how inflation can distort the allocation of resources and adversely affect economic efficiency.

4. The Cost of Fighting Inflation

The analysis thus far suggests that there is a "free lunch" to be had by reducing the rate of inflation. Yet the U.S. experience in the early 1980s shows that reductions in inflation are often bought at considerable short-term costs in terms of lower output and higher unemployment. These costs are absent from the calculation in the previous section because they are derived by assuming that the relevant comparison is between two distinct economies that differ only with regard to their rates of inflation and the economic effects that these differences imply. 

Policymakers often use the "sacrifice ratio" to try to get a handle on these shortterm costs. In brief, the sacrifice ratio gives the cumulative loss in output (over some time horizon) associated with a 1 percentage point reduction in the inflation rate. 

A typical exercise is the following: Estimate a simple relationship between real growth and inflation. Next, generate an artificial time series while imposing a reduction in the inflation rate. Finally, add up the shortfall in output (the deviation of output from the path that it would have taken) and divide by the resulting fall in inflation (in order to express the lost output relative to a 1 percentage point fall in inflation). A stylized example of such an exercise is presented in figure 1. 

There are at least two problems with the sacrifice ratio approach. First, the statistical techniques used typically provide no room for subsequent benefits of lower inflation. More specifically, in the long run, this statistical exercise produces an output growth rate equal to that in the data sample used to estimate that relationship. 

Roughly speaking, common practice would involve adding up the shaded area in figure 1. If inflation is costly, we would expect to observe either an increase in the level of output, an increase in its growth rate, or both. Thus, following a disinflation, we might expect output to follow a path like that given in figure 2, in which the shortterm losses in output are offset by medium- and long-term gains. Of course, one could argue that ignoring the growth effects of lower inflation is appropriate since the long-run benefits of a disinflation are so far off in the future that they can safely be ignored. One would hope that policymakers are not so short sighted. 

Second, and more importantly, the sacrifice ratio gives the loss in output, not the loss in utility (or its output equivalent). This is an important distinction since the wellbeing of the typical American depends only in part on his or her material consumption. A different way to see this point is to realize that while we could all have more goodies to enjoy if everyone would work 60-hour weeks, we are unlikely to be happier since we would have much less leisure time in which we could enjoy these goodies. 

That is not to suggest, however, that the transition costs from higher to lower long-run inflation rates are, or should be, of no concern. An important agenda for economists working within the methodology of general equilibrium macroeconomic models is to design models in which the long-run rate of inflation periodically changes. Doing so would allow a more complete assessment of the welfare benefits of a disinflation, incorporating the short-run losses in utility along with the long-term gains.

Figure 1 Output Loss After Disinflation: Sacrifice Ratio Approach 


Figure 2 Ongoing Gains After Disinflation: Economic Approach