From the MicroEconomics Essentials
The Costs of Inflation

Economists do not pay much heed to the usual complaints about inflation. For most people the impact of rising prices is offset by rising wages. Those living on fixed incomes, such as welfare recipients or old-age pensioners, can (although may not) be protected through appropriate policy action. Arbitrary redistribution of wealth, such as rises in real estate values, comes about mainly if an inflation is unanticipated, in which case economists would condemn it.

From their study of microeconomics economists know that our economic system works well because prices act as signals to induce producers to produce the things we value most at the lowest cost—the right prices ensure that the economy maximizes the total welfare of its participants. This is what is meant when it is said that the price system is a very efficient way of allocating and distributing goods and services. To economists, the main cost of inflation is the resource misallocation it causes—the loss of efficiency that results because inflation distorts price signals. This happens in many different ways, some examples of which follow.

-During periods of inflation people are more interested in investing their savings in assets designed to protect them against inflation, such as real estate, rather than in productive investments that enhance the growth and efficiency of the economy. A classic example is people in Brazil holding wealth in the form of Volkswagens during high-inflation periods.

- During high inflation business finds it worthwhile to collect bills more promptly, using resources for this purpose that could otherwise have been used to produce goods or provide other services.

- Low inflations are steady and predictable; high inflations are volatile and unpredictable. This volatility creates uncertainty in the business community, reducing investment activity. Reduced investment in turn reduces economic growth. Some estimates suggest that reducing inflation from 10 percent to 5 percent will increase productivity by about 0.2 percent per year.

- Individuals reduce money holdings to cut wealth losses caused by rising prices lowering the purchasing power of their cash and checking accounts. Getting along with fewer money holdings is inconvenient, misallocating the individual's personal resources of time, energy, and leisure. The cost of this inconvenience is estimated to be equivalent to about 0.05 percent of GDP per extra percentage point of inflation above normal.

- In the extreme case of hyperinflation, inflation of over 100 percent per year, the currency system breaks down, and the economy reverts to the far less efficient barter system. During the spectacular German hyperinflation of 1923 prices at times rose by over 200 percent per week, severely affecting economic activity—people would work only if paid immediately, and spent every spare moment buying things to get rid of cash.

Offsetting these arguments, however, is the fact that many prices are inflexible or "sticky" in the downward direction. Many prices that should fall tend not to do so, instead just remaining constant. This implies that for the price system to operate efficiently, relative prices must change through selected price increases, rather than by having some prices rise and others fall. In reality the efficiencies of the price system can be gained only by allowing some inflation.

Most laypersons are amazed to discover that economists' measure of the harm done by inflation reflects phenomena of such seemingly little severity. It seems there are few substantive costs to modest inflation, and some benefits. Why, then, are we so paranoid about inflation?

For reasons explained at length later in this book, inflation is very quick to rise but very slow to fall. Although a low, steady rate of inflation does not carry significant cost, to bring inflation down to this level a high cost must be paid in the form of a prolonged period of high unemployment. We fear inflation because if it rises above the modest level we are willing to live with, we will have to pay a high unemployment cost to bring it back down.