Fifty years ago, economists didn’t think that inflation caused many economic problems. Then, in the late 1960s and throughout the 1970s, inflation rose to double-digit levels in the United States and many other countries. We learned that the costs of inflation may be significant and that a low inflation rate is ideal.
The problems caused by inflation can be divided into two parts: one based on the level of inflation itself (that is, an inflation rate of 8% is worse than an inflation rate of 2%) and another based on uncertainty about inflation (that is, a situation in which you don’t know if the inflation rate will be 3% or 5% is worse than a situation with a known inflation rate of 4%).
Problems Caused by Inflation
Inflation creates a number of problems for the economy: (1) shoe-leather costs; (2) menu costs; (3) imperfect taxation; and (4) a tilt in mortgage payments.
The first cost of inflation is what economists call shoe-leather costs, which is a euphemism for the costs that society incurs when people go to the bank frequently as they try to keep less cash in their pockets. When inflation occurs, your cash loses value because it earns no interest. If inflation is 10% and you keep $100 in your wallet, on average, you lose $10 each year in purchasing power. To minimize that cost, you might go to the bank more often and keep less cash in your wallet. The cost to individuals is fairly small, but for business firms that might have millions of dollars in cash outstanding, for example at retail stores, these costs can be quite high.
A second important cost of inflation is menu costs. These costs arise because inflation causes firms to have to change their prices frequently. The most obvious cost is for restaurants that may have fancy menus that are expensive to produce. Many other firms face this cost, especially firms that list their prices in large catalogues. Customers don’t like it when prices are constantly changing and firms cannot honor the prices they have printed in their catalogues. This problem is mitigated somewhat if the prices are only shown on the firm’s web site because those prices can be changed quickly, but the problem remains significant for many firms.
The third problem with inflation, which is even more significant, is that our tax system is distorted significantly by the presence of inflation. The higher the inflation rate is, the bigger the distortion is. The cost of a 6% inflation rate is more than twice the cost of a 3% inflation rate. The source of the problem is that the U.S. tax system is based entirely on dollar amounts. But the economic system is based on inflation-adjusted amounts. Those two systems clash strongly when inflation occurs.
Here is an example. Suppose you invest $10,000 in a stock that pays a 5% inflation-adjusted return each year and suppose you are in the 40% tax bracket (combining U.S., state, and local income taxes). If inflation is 0% and the inflation-adjusted return is 5%, then you earn a dollar return of 5% (note that the inflation-adjusted return plus the inflation rate equals the return in terms of dollars, so 5% + 0% = 5%). In dollars, you earn 5% × $10,000 = $500. Your tax will be 40% of the $500 return, which is 0.4 × $500 = $200. So, of the $500 that you earned, you get to keep $300 and the government keeps $200.
But what if the inflation rate is 10%? If you get the same inflation-adjusted return of 5%, the return on your investment is 15% in terms of dollars (5% inflation-adjusted return + 10% inflation = 15% return in dollar terms). In dollar terms, you earn 0.15 × $10,000 = $1,500. Now you are taxed 40% on your dollar return, so you will pay taxes of 0.4 × $1,500 = $600. You earn $900 after taxes and pay $600 in taxes. You might think that is fine, but now calculate how much the value of your stock has declined because of inflation. With a 10% inflation rate, your $10,000 worth of stock is now worth $1,000 less. So, in inflation-adjusted terms, your return is actually negative. In dollar terms, you got a $900 return but the value of your investment fell by $1,000, so your inflation-adjusted return is –$100, or –1%.
Why is your return negative? The main reason is that the government taxed you on the dollar amount of your return, rather than the inflation-adjusted amount of your return. One way to look at it is that of the 15% return in dollar terms that your stock generated, inflation got 10% of it, the government got 6% of it, and you got –1% of it; or in inflation-adjusted terms, the government gets 6% and you get –1% of the total inflation-adjusted return of 5%.
So, the higher inflation is, the more the government gets of your income and the less you get. That’s why sometimes governments create inflation to get out of budget problems—they get much more tax revenue and the inflation-adjusted value of their debt declines.
The fourth and final major problem related to inflation is that it distorts people’s mortgage payments. This is another fairly subtle problem that most people don’t realize is happening. The basic idea is that, the higher inflation is, the higher the mortgage interest rate is, and the inflation-adjusted value of your mortgage payment declines over time. This means that it costs you much more in inflation-adjusted terms to pay your mortgage early on and much less later. Here is an example.
Consider two situations, one in which inflation is 0% and one in which the inflation rate is 10%. In the low inflation case, suppose your mortgage interest rate is 4% but in the high inflation case it is 14%, so in both cases the mortgage interest rate equals 4% plus the inflation rate. How much would your monthly payment be on a $200,000 30-year mortgage? If inflation is 0%, your monthly payment would be $954.83. If inflation is 10%, your monthly payment would be $2369.74. Your monthly payment on your mortgage is much higher when inflation is 10% than if inflation is 0%. When you combine this with the fact that to qualify for a mortgage your monthly mortgage and total debt payments must not exceed a certain fraction of your income, you can see that when inflation is high, homebuyers will have to buy smaller homes to keep the monthly payments affordable. This problem is aggravated by the mortgage-tilt problem, which is illustrated in the next chart.
Chart: The Mortgage-Tilt Problem
Source: Author’s calculations
As the chart shows, when inflation is zero, the real (inflation-adjusted) value of the monthly mortgage payments is constant over time. But when inflation is high (10% in this case), the monthly payments are tilted; they are high early in the life of the mortgage and lower later in the life of the loan. This mortgage tilt creates a problem because you qualify for a loan based on the initial payment. So, when inflation is high, your mortgage is least affordable in the early years, and much more affordable in the past 10 years. But the result is that you may have to buy a smaller home when inflation is high because of the mortgage-tilt problem.