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.

5. Summary

There can be little doubt that the disinflation of the early 1980s was costly. The United States suffered the worst recession since the Great Depression, and the unemployment rate reached its highest level in post–World War II history. However, those short-term costs have hopefully been paid for by the subsequent strong economic performance of the U.S. economy, including the longest expansion in U.S. history. This is not to suggest that all of the positive economic performance since the early 1980s can be attributed to judicious monetary policy. However, it is probably fair to say that good monetary policy was a necessary precondition for this unprecedented performance. 

In the 1979–80 period, the annual rate of inflation averaged over 121/2 percent; by 1982, it was under 4 percent. The quantitative literature on the costs of inflation suggests that sustained differences of this magnitude have substantial welfare consequences for the economy. Maintaining the gains from lower inflation is not, however, automatic. It is useful to recall that prior to the last recession, inflation was accelerating rapidly, rising from just over 1 percent in mid-1986 to over 6 percent by mid-1990. Had this trend continued, the gains of the 1990s would have very much been at risk. As the short-run risks to the U.S. economy shift, for now, in the direction of economic weakness, it is important to remember why the central bank's focus can never stray too far from its primary role in delivering the gains made possible by maintaining the purchasing power of the nation's currency.