As we mentioned in the opening story, in early 2011 British officials were worried about two things: the unemployment rate was high and so was inflation. And there was a fierce debate about which concern should take 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 Canada did something other countries have done from time to time—replacing 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. (February 17, 2012 was the last day for the French residents to exchange their old French currency for the 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 = 5.2449 euros per hour, and so on. This kind of currency conversion has also happened in other countries, such as Brazil. In an attempt to address the issue of high inflation, Brazil introduced a new currency, the Brazilian real, to replace the old currency, the Brazilian cruzerio, in 1994.

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 Canadian price level back to about what it was in 1965, when Lester B. Pearson was the prime minister.

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—hasn’t changed. In fact, bringing the overall price level back to what it was during the Pearson 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 mid-1960s hasn’t made Canada poorer because real income—nominal income (income that has not been adjusted for inflation and decreasing purchasing power) divided by the price level—has also increased. Real income per person increased at an average rate of 1.9% per year between 1965 and 2011.

The moral of this story is that the level of prices doesn’t matter: Canada would be no richer than it is now if the overall level of prices was still as low as it was in 1965; conversely, the rise in prices over the past half century 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: the percent increase in the overall level of prices per year. Recall from Chapter 7 that the inflation rate is defined as follows:

Figure 8-10 highlights the difference between the price level and the inflation rate in Canada over the last half-century, 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 Canada was much higher than it had been in 1960—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 cheques—for convenience in making transactions. A high inflation rate, however, discourages people from holding money because the purchasing power of the cash in your wallet and the funds in your bank account 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.

The Economics in Action at the end of this section describes how Israelis spent a lot of time at the bank during the periods of high inflation rates that afflicted Israel in 1984–1985. 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 each case, in an effort to avoid having the purchasing power of their money eroded, people used up valuable resources, such as time for Israeli citizens and the labour of those German 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 Canada measured as a share of GDP. The large increase in the Brazilian banking sector needed to cope with the consequences of inflation represented a loss of real resources to its society.

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, 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 Canada—which in peacetime has never had inflation above 13%—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 back of a book, 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 prices in a supermarket requires sending clerks through the store to change the listed price under each item. In the face of inflation, of course, firms are forced to change prices more often than they would if the aggregate price level was more or less stable. This means higher costs for the economy as a whole.

In times of very high inflation, 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 inflation 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%. By 2009, the government had suspended the Zimbabwean dollar, allowing Zimbabweans to buy and sell goods using foreign currencies.

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.

During any period of inflation, not all prices are changing by the same percentage, and this causes a change in relative prices. Since consumers and producers use relative prices in decision-making, such changes can create positive and negative welfare impacts for some agents.

Unit-of-Account Costs In the Middle Ages, contracts were often specified “in kind”: a tenant might, for example, 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.

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 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, then resells it a year later for $110 000. In a fundamental sense, the business didn’t make a profit on the deal: in real terms, the value of the land remains unchanged. For example, if the general price level is $5 today and $5.50 a year later (due to 10% inflation), the real value of the land is $20 000 ($100 000/$5) today and $20 000 ($110 000/$5.5) a year from now. But Canada’s tax law would say that the business made a capital gain of $10 000, and it would have to pay taxes on that capital (“phantom”) gain.

During the 1970s, when Canada had relatively high inflation, 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 inflation began to fall in the 1980s and since it stabilized around 2% in the 1990s—and tax rates were reduced—these problems became much less important.

The government can reduce some of the problems inflation creates for the income tax system by indexing tax brackets to the rate of inflation so that only real income gains, not nominal income gains, will be taxed. In Canada, our tax and welfare systems are indexed to the CPI inflation rate. Both Old Age Security (OAS) benefits and Canada Pension Plan (CPP) benefits are indexed to the consumer price index to reflect changes in the cost of living—this helps maintain the “real” value or purchasing power of these benefit payments. CPP benefit payments are adjusted on an annual basis, while OAS benefits are revised four times a year (in January, April, July, and October).

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 often involve contracts that extend over a period of time, such as loans, 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 the interest rate on the loan and when it must be paid off. The interest rate is the return a lender receives for allowing borrowers the use of their savings for one year, calculated as a percentage of the amount borrowed.

But what that dollar 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. Economists summarize the effect of inflation on borrowers and lenders by distinguishing between the nominal interest rate and the real interest rate. The nominal interest rate is the interest rate in dollar terms—for example, the interest rate on a student loan. The nominal interest rate is the interest we see in our daily lives. The real interest rate is the nominal interest rate minus the rate of inflation. For example, if a loan carries an interest rate of 8%, but there is 5% inflation, the real interest rate is 8% – 5% = 3%.

When a borrower and a lender enter into a loan contract, the contract is normally written in dollar terms—that is, the interest rate it specifies is a nominal interest rate. (And in later chapters, when we say the interest rate we will mean the nominal interest rate unless noted otherwise) But each party to a loan contract 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. 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.

The above example shows that unexpected inflation, the difference between the actual and expected rates of inflation, may redistribute wealth arbitrarily among members of the economy, creating unexpected winners and losers. For typical Canadian households, home mortgages are the most important source of gains and losses from unexpected inflation. In the 1970s, inflation was higher than expected, so that in 1983 the purchasing power of a dollar was 41% of what it had been in 1973. As a result, Canadians who took out mortgages in the 1970s benefitted, because their real payments were substantially reduced. But those who took out mortgages in the early 1990s were not so lucky. At that time, inflation occurred at a lower rate than expected, partly because in 2003 the purchasing power of a dollar was 82% 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. In countries with high and uncertain inflation, long-term loans are rare, which makes it difficult in many cases to make long-term investments.

Similar to unexpected inflation, unexpected deflation—a surprise fall in the price level—creates winners and losers, too. During the Great Depression, Canada experienced deflation. Between 1929 and 1933, the consumer price index fell by 26%. 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. Since the Great Depression, Canada’s annual inflation rate has generally remained positive with the exception of 1953 when the inflation rate was –1.4%. Figure 8-10 shows that our inflation rate has fluctuated around 2% in recent years, which, as you will see later in the chapter, is due mostly to the successful efforts of the Bank of Canada to maintain this target level. We will discuss the effects of deflation in more detail in Chapter 16.

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 8-11 shows what happened during two major episodes of disinflation in Canada, in the early 1980s and in the early 1990s. The horizontal axis shows the unemployment rate. The vertical axis shows “core” inflation over the previous year, a measure that excludes volatile food and energy prices and is widely considered a better measure of underlying inflation than overall consumer prices. Each marker represents the inflation rate and the unemployment rate for one month. In each episode, unemployment and inflation followed a sort of clockwise spiral, with high inflation gradually falling in the face of an extended period of very high unemployment.

According to many economists, these periods of high unemployment that temporarily depressed the economy were necessary to reduce inflation that had become deeply embedded in 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. To alleviate the problems that disinflation and high rates of inflation can cause, Canada adopted, in 1991, the policy of having an inflation-control target that lets the public know what inflation rate is likely to prevail in the economy. As a result, households and firms have the opportunity to reduce their costs by making wiser economic decisions. In November 2011, the inflation target was renewed with a target inflation rate of 2% and a target range of 1 to 3%. The inflation-control target in Canada will be discussed in greater detail in Chapter 16.