In 1980 Americans were dismayed about the state of the economy for two reasons: the unemployment rate was high, and so was inflation. In fact, the high rate of inflation, not the high rate of unemployment, was the principal concern of policy makers at the time—so much so that Paul Volcker, the chairman of the Federal Reserve Board (which controls monetary policy), more or less deliberately created a deep recession in order to bring inflation under control. Only in 1982, after inflation had dropped sharply and the unemployment rate had risen to more than 10%, did fighting unemployment become the chief priority.

Why is inflation something to worry about? Why do policy makers even now get anxious when they see the inflation rate moving upward? The answer is that inflation can impose costs on the economy—but not in the way most people think.

The most common complaint about inflation, an increase in the price level, is that it makes everyone poorer—after all, a given amount of money buys less. But inflation does not make everyone poorer. To see why, it’s helpful to imagine what would happen if the United States did something other countries have done from time to time—replaced the dollar with a new currency.

An example of this kind of currency conversion happened in 2002, when France, like a number of other European countries, replaced its national currency, the franc, with the new Pan-European currency, the euro. People turned in their franc coins and notes, and received euro coins and notes in exchange, at a rate of precisely 6.55957 francs per euro. At the same time, all contracts were restated in euros at the same rate of exchange. For example, if a French citizen had a home mortgage debt of 500,000 francs, this became a debt of 500,000/6.55957 = 76,224.51 euros. If a worker’s contract specified that he or she should be paid 100 francs per hour, it became a contract specifying a wage of 100/6.55957 = 15.2449 euros per hour, and so on.

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You could imagine doing the same thing here, replacing the dollar with a “new dollar” at a rate of exchange of, say, 7 to 1. If you owed $140,000 on your home, that would become a debt of 20,000 new dollars. If you had a wage rate of $14 an hour, it would become 2 new dollars an hour, and so on. This would bring the overall U.S. price level back to about what it was when John F. Kennedy was president.

So would everyone be richer as a result because prices would be only one-seventh as high? Of course not. Prices would be lower, but so would wages and incomes in general. If you cut a worker’s wage to one-seventh of its previous value, but also cut all prices to one-seventh of their previous level, the worker’s real wage—the wage rate divided by the price level to adjust for the effects of inflation or deflation—doesn’t change. In fact, bringing the overall price level back to what it was during the Kennedy administration would have no effect on overall purchasing power, because doing so would reduce income exactly as much as it reduced prices. Conversely, the rise in prices that has actually taken place since the early 1960s hasn’t made America poorer, because it has also raised incomes by the same amount: real income—income divided by the price level to adjust for the effects of inflation or deflation—hasn’t been affected by the rise in overall prices.

The moral of this story is that the level of prices doesn’t matter: the United States would be no richer than it is now if the overall level of prices was still as low as it was in 1961; conversely, the rise in prices over the past 45 years hasn’t made us poorer.

The conclusion that the level of prices doesn’t matter might seem to imply that the inflation rate doesn’t matter either. But that’s not true.

To see why, it’s crucial to distinguish between the level of prices and the inflation rate. In the next module, we will discuss precisely how the level of prices in the economy is measured using price indexes such as the consumer price index. For now, let’s look at the inflation rate, the percentage increase in the overall level of prices per year. The inflation rate is calculated as follows:

Figure 14.1 highlights the difference between the price level and the inflation rate in the United States since 1969, with the price level measured along the left vertical axis and the inflation rate measured along the right vertical axis. In the 2000s, the overall level of prices in the United States was much higher than it was in 1969—but that, as we’ve learned, didn’t matter. The inflation rate in the 2000s, however, was much lower than in the 1970s—and that almost certainly made the economy richer than it would have been if high inflation had continued.

Economists believe that high rates of inflation impose significant economic costs. The most important of these costs are shoe-leather costs, menu costs, and unit-of-account costs. We’ll discuss each in turn.

Shoe-Leather Costs People hold money—cash in their wallets and bank deposits on which they can write checks—for convenience in making transactions. A high inflation rate, however, discourages people from holding money, because the purchasing power of the cash in their wallets and the funds in their bank accounts steadily erodes as the overall level of prices rises. This leads people to search for ways to reduce the amount of money they hold, often at considerable economic cost.

During the most famous of all inflations, the German hyperinflation of 1921–1923, merchants employed runners to take their cash to the bank many times a day to convert it into something that would hold its value, such as a stable foreign currency. In an effort to avoid having the purchasing power of their money eroded, people used up valuable resources—the time and labor of the runners—that could have been used productively elsewhere. During the German hyperinflation, so many banking transactions were taking place that the number of employees at German banks nearly quadrupled—from around 100,000 in 1913 to 375,000 in 1923. More recently, Brazil experienced hyperinflation during the early 1990s; during that episode, the Brazilian banking sector grew so large that it accounted for 15% of GDP, more than twice the size of the financial sector in the United States measured as a share of GDP. The large increase in the Brazilian banking sector that was needed to cope with the consequences of inflation represented a loss of real resources to its society.

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Increased costs of transactions caused by inflation are known as shoe-leather costs, an allusion to the wear and tear caused by the extra running around that takes place when people are trying to avoid holding money. Shoe-leather costs are substantial in economies with very high inflation rates, as anyone who has lived in such an economy—say, one suffering inflation of 100% or more per year—can attest. Most estimates suggest, however, that the shoe-leather costs of inflation at the rates seen in the United States—which in peacetime has never had inflation above 15%—are quite small.

Menu Costs In a modern economy, most of the things we buy have a listed price. There’s a price listed under each item on a supermarket shelf, a price printed on the front page of your newspaper, a price listed for each dish on a restaurant’s menu. Changing a listed price has a real cost, called a menu cost. For example, to change a price in a supermarket may require a clerk to change the price listed under the item on the shelf and an office worker to change the price associated with the item’s UPC code in the store’s computer. In the face of inflation, of course, firms are forced to change prices more often than they would if the price level was more or less stable. This means higher costs for the economy as a whole.

In times of very high inflation rates, menu costs can be substantial. During the Brazilian inflation of the early 1990s, for instance, supermarket workers reportedly spent half of their time replacing old price stickers with new ones. When the inflation rate is high, merchants may decide to stop listing prices in terms of the local currency and use either an artificial unit—in effect, measuring prices relative to one another—or a more stable currency, such as the U.S. dollar. This is exactly what the Israeli real estate market began doing in the mid-1980s: prices were quoted in U.S. dollars, even though payment was made in Israeli shekels. And this is also what happened in Zimbabwe when, in May 2008, official estimates of the inflation rate reached 1,694,000%.

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Menu costs are also present in low-inflation economies, but they are not severe. In low-inflation economies, businesses might update their prices only sporadically—not daily or even more frequently, as is the case in high-inflation or hyperinflation economies. Also, with technological advances, menu costs are becoming less and less important, since prices can be changed electronically and fewer merchants attach price stickers to merchandise.

Unit-of-Account Costs In the Middle Ages, contracts were often specified “in kind”: for example, a tenant might be obliged to provide his landlord with a certain number of cattle each year (the phrase in kind actually comes from an ancient word for cattle). This may have made sense at the time, but it would be an awkward way to conduct modern business. Instead, we state contracts in monetary terms: a renter owes a certain number of dollars per month, a company that issues a bond promises to pay the bondholder the dollar value of the bond when it comes due, and so on. We also tend to make our economic calculations in dollars: a family planning its budget, or a small business owner trying to figure out how well the business is doing, makes estimates of the amount of money coming in and going out.

This role of the dollar as a basis for contracts and calculation is called the unit-of-account role of money. It’s an important aspect of the modern economy. Yet it’s a role that can be degraded by inflation, which causes the purchasing power of a dollar to change over time—a dollar next year is worth less than a dollar this year. The effect, many economists argue, is to reduce the quality of economic decisions: the economy as a whole makes less efficient use of its resources because of the uncertainty caused by changes in the unit of account, the dollar. The unit-of-account costs of inflation are the costs arising from the way inflation makes money a less reliable unit of measurement.

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Unit-of-account costs may be particularly important in the tax system, because inflation can distort the measures of income on which taxes are collected. Here’s an example: assume that the inflation rate is 10%, so that the overall level of prices rises 10% each year. Suppose that a business buys an asset, such as a piece of land, for $100,000 and then resells it a year later at a price of $110,000. In a fundamental sense, the business didn’t make a profit on the deal: in real terms, it got no more for the land than it paid for it, because the $110,000 would purchase no more goods than the $100,000 would have a year earlier. But U.S. tax law would say that the business made a capital gain of $10,000, and it would have to pay taxes on that phantom gain.

During the 1970s, when the United States had a relatively high inflation rate, the distorting effects of inflation on the tax system were a serious problem. Some businesses were discouraged from productive investment spending because they found themselves paying taxes on phantom gains. Meanwhile, some unproductive investments became attractive because they led to phantom losses that reduced tax bills. When the inflation rate fell in the 1980s—and tax rates were reduced—these problems became much less important.

As we’ve just learned, a high inflation rate imposes overall costs on the economy. In addition, inflation can produce winners and losers within the economy. The main reason inflation sometimes helps some people while hurting others is that economic transactions, such as loans, often involve contracts that extend over a period of time and these contracts are normally specified in nominal—that is, in dollar—terms. In the case of a loan, the borrower receives a certain amount of funds at the beginning, and the loan contract specifies how much he or she must repay at some future date. But what that dollar repayment is worth in real terms—that is, in terms of purchasing power—depends greatly on the rate of inflation over the intervening years of the loan.

The interest rate on a loan is the percentage of the loan amount that the borrower must pay to the lender, typically on an annual basis, in addition to the repayment of the loan amount itself. Economists summarize the effect of inflation on borrowers and lenders by distinguishing between nominal interest rates and real interest rates. The nominal interest rate is the interest rate that is actually paid for a loan, unadjusted for the effects of inflation. For example, the interest rates advertised on student loans and every interest rate you see listed by a bank is a nominal rate. The real interest rate is the nominal interest rate adjusted for inflation. This adjustment is achieved by simply subtracting the inflation rate from the nominal interest rate. For example, if a loan carries a nominal interest rate of 8%, but the inflation rate is 5%, the real interest rate is 8% − 5% = 3%.

When a borrower and a lender enter into a loan contract, the contract normally specifies a nominal interest rate. But each party has an expectation about the future rate of inflation and therefore an expectation about the real interest rate on the loan. If the actual inflation rate is higher than expected, borrowers gain at the expense of lenders: borrowers will repay their loans with funds that have a lower real value than had been expected—they can purchase fewer goods and services than expected due to the surprisingly high inflation rate. Conversely, if the inflation rate is lower than expected, lenders will gain at the expense of borrowers: borrowers must repay their loans with funds that have a higher real value than had been expected.

Historically, the fact that inflation creates winners and losers has sometimes been a major source of political controversy. In 1896 William Jennings Bryan electrified the Democratic presidential convention with a speech in which he declared, “You shall not crucify mankind on a cross of gold.” What he was actually demanding was an inflationary policy. At the time, the U.S. dollar had a fixed value in terms of gold. Bryan wanted the U.S. government to abandon the gold standard and print more money, which would have raised the level of prices and, he believed, helped the nation’s farmers who were deeply in debt.

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In modern America, home mortgages (loans for the purchase of homes) are the most important source of gains and losses from inflation. Americans who took out mortgages in the early 1970s quickly found their real payments reduced by higher-than-expected inflation: by 1983, the purchasing power of a dollar was only 45% of what it had been in 1973. Those who took out mortgages in the early 1990s were not so lucky, because the inflation rate fell to lower-than-expected levels in the following years: in 2003 the purchasing power of a dollar was 78% of what it had been in 1993.

Because gains for some and losses for others result from inflation that is either higher or lower than expected, yet another problem arises: uncertainty about the future inflation rate discourages people from entering into any form of long-term contract. This is an additional cost of high inflation, because high rates of inflation are usually unpredictable, too. In countries with high and uncertain inflation, long-term loans are rare. This, in turn, makes it difficult for people to commit to long-term investments.

One last point: unexpected deflation—a surprise fall in the price level—creates winners and losers, too. Between 1929 and 1933, as the U.S. economy plunged into the Great Depression, the price level fell by 35%. This meant that debtors, including many farmers and homeowners, saw a sharp rise in the real value of their debts, which led to widespread bankruptcy and helped create a banking crisis, as lenders found their customers unable to pay back their loans.

There is not much evidence that a rise in the inflation rate from, say, 2% to 5% would do a great deal of harm to the economy. Still, policy makers generally move forcefully to bring inflation back down when it creeps above 2% or 3%. Why? Because experience shows that bringing the inflation rate down—a process called disinflation—is very difficult and costly once a higher rate of inflation has become well established in the economy.

Figure 14.2 shows the inflation rate and the unemployment rate in the United States over a crucial decade, from 1978 to 1988. The decade began with an alarming rise in the inflation rate, but by the end of the period inflation averaged only about 4%. This was considered a major economic achievement—but it came at a high cost. Much of the fall in inflation probably resulted from the very severe recession of 1981–1982, which drove the unemployment rate to 10.8%—its highest level since the Great Depression.

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Many economists believe that this period of high unemployment was necessary, because they believe that the only way to reduce inflation that has become deeply embedded in the economy is through policies that temporarily depress the economy. The best way to avoid having to put the economy through a wringer to reduce inflation, however, is to avoid having a serious inflation problem in the first place. So, policy makers respond forcefully to signs that inflation may be accelerating as a form of preventive medicine for the economy.