The costs of inflation – what have we learned?

David Gillmore

This article reviews what we know about the long-run impact of inflation on economic growth. Economic theory tells
us that both high inflation and deflation adversely affect the economy. Inflation tends to benefit the wealthy at the
expense of the poor and those on fixed incomes and it reduces economic growth over the long term. The experiences of
New Zealand and other industrialised countries since World War II generally support this negative long-term relationship
between inflation and growth. The experience of Japan illustrates the negative impact of deflation. There is general
agreement that both high inflation and deflation impact negatively on the economy. Recent empirical studies have
estimated the level of inflation at which its long-run impact on growth becomes materially negative. For industrialised
countries, this level is about 3 percent, while for developing countries it is around 11 to 12 percent.

1 Introduction literature, in this paper we focus on inflation’s effects on

growth.

Our economic system will work best when producers and How do the data support this theory? In section 3, the

consumers, employers and employees, can proceed with full record of inflation and economic growth in industrialised

confidence that the average level of prices will behave in a countries since the end of World War II reveals that periods

known way in the future – preferably that it will be highly of low inflation have generally been associated with higher

stable. and more stable growth than when inflation has been high

Milton Friedman1 and variable.

Section 4 summarises the findings of studies that use

sophisticated econometric techniques that aim at verifying
One of the basic principles of economics is that inflation is
the impact of inflation on economic activity. These techniques
bad for economic growth. There is strong evidence that very
take account of other factors that may drive both inflation
high inflation is damaging to an economy – as was seen in
and output growth and influence the correlations observed in
Germany in the 1920s and currently in Zimbabwe. Equally,
the data. Recent studies have estimated the rates of inflation
negative inflation (deflation) appears to be incompatible
above which the negative effects of inflation appear. Section
with healthy economic growth, as in Japan during the 1990s
5 concludes.
and early this decade. It seems clear that both high inflation
and deflation impact negatively on a society’s standard of
living and on individuals’ quality of life. But “there is less
2 Costs of inflation: theoretical
conclusive evidence whether moderate inflation is harmful
or not”.2
arguments
This section summarises theoretical arguments concerning
This article discusses the reasons why inflation is bad for an
the negative long-run impacts of inflation on the economy.3
economy. Section 2 summarises the reasons economists give
In general, inflation impacts negatively on growth and the
for how inflation impacts on the economy. These include
distribution of income or wealth. The impact of inflation
redistributive costs (inflation benefits some people at the
depends on whether it is anticipated or not. Anticipated
expense of others) and negative effects on the level of
inflation impacts negatively on growth, through the cost of
output and the rate of growth (inflation creates damaging
inefficiencies in the economy). In line with much of the 3
In the short term (for example, within three years),
there is generally a positive relationship between
inflation and economic growth. When economic
1
Friedman (1968), p.13. activity rises above its potential level, inflation rises.
2
Bernanke et al. (1990), p.17. This relationship is known as the Phillips curve.

26 Reserve Bank of New Zealand: Bulletin, Vol. 71, No. 3, September 2008
changing prices, the cost of holding cash, and variability in incomes creeping up into higher tax brackets, and being
relative prices. Through the tax system, it also reduces real subject to higher marginal rates of income tax. Secondly, the
value of savings and fixed incomes. Unanticipated inflation tax that is charged on the interest earned on bank deposits

has both redistributive consequences and negative effects is based on the nominal (rather than real) value of deposits.

on growth. 4 Therefore both the portion of the interest that goes towards
maintaining the deposit’s purchasing power and the portion
that is real income from the deposit are taxed. To illustrate
The impact of anticipated inflation on this, if we assume that the rate of inflation and the interest
economic activity and growth rate paid on a bank deposit are both 5 percent, the interest
The higher the general rate of inflation, the more often paid is just sufficient to maintain the real value (purchasing

firms must change prices. This comes at a cost, whether power) of the deposit at a constant level. Any income tax

in printing new menus, re-pricing of items on display in on this interest will therefore reduce the real value of the

retail stores, updating computer files, or in the potential deposit.

negative impact on customer loyalty. Because of the cost

involved in changing prices, some firms delay doing so, thus
resulting in variability in price changes among firms. Faced
Redistributive effects of unanticipated

with this variability, both individuals and firms need to spend inflation
more time and resources obtaining relevant information In the case of long-term loans, if inflation is different from that

before making decisions. Thus inflation reduces the level of which is anticipated, the return that the borrower eventually

productive economic activity. pays the lender differs from what each anticipated. If the
inflation is higher than that expected when the loan was
Inflation creates costs of holding cash and balances in non-
negotiated, the borrower gains at the expense of the lender.
interest bearing bank accounts. To overcome these costs,
Those paying off mortgages at fixed rates of interest will
people tend to hold less cash, and maintain higher balances
benefit, while those who hold fixed interest-bearing bank
in interest-bearing accounts, withdrawing only when they
accounts suffer. Thus there is, in effect, a wealth transfer
need it. Potentially, there are costs to this activity also, both
from the latter group to the former. The reverse will be true
in the time needed and in possible missed opportunities due
if inflation is lower than anticipated.
to not having cash on hand.
Unanticipated inflation benefits borrowers because inflation
causes the real value of their debt to diminish. Because

The redistributive effects of anticipated debt is usually stated in nominal terms (it is not indexed to
inflation), its real value declines as the price level increases.
inflation
As their incomes rise in line with the general increase in the
Inflation causes a deterioration of the real value of incomes
price level over time, borrowers find it easier to repay loans,
fixed in nominal terms, such as benefits. This is usually
as inflation reduces the value of their loan and repayments
overcome by governments indexing benefits to the rate of
relative to their increasing incomes.
inflation. However, because benefits are usually adjusted by
the previous period’s inflation rate, their purchasing power Another way to look at it is that unanticipated inflation

deteriorates between indexation adjustments. causes the real value of savings to decline, especially when
real interest rates are negative. That is, when the inflation rate
Inflation also causes loss of both income and savings
is higher than the interest paid on savings, the purchasing
through the progressive income tax system. Firstly, with a
power of savings is reduced. Thus, the financial worth of
general wage and price increase, individuals can find their
savers goes down. We note that those on fixed incomes are
4
More detailed accounts of the arguments in this affected in two ways by inflation – by the reduction of the
section can be found in Johnson (1993) and Briault
(1995). real value of both their incomes and their savings.

Reserve Bank of New Zealand: Bulletin, Vol. 71, No. 3, September 2008 27
Inflation variability and uncertainty impacts to consumers in higher prices. Secondly, inflation easily leads

on economic activity to expectations within the economy of continuing inflation.

When inflation is high, it is usually volatile as well. Why While the wage-price spiral and inflation expectations do

is this so? Milton Friedman suggested that it can be the not constitute costs of inflation themselves, they add to

result of the way government policies are adjusted.5 In this the persistence of inflation and therefore add to any of the

view, high inflation itself is usually the result of government negative effects of inflation. It is very costly to bring high

policies (such as welfare policies) involving strong growth inflation back to lower levels. Countries typically experience

in government spending. But because governments also recessions when tight monetary policies are needed to

usually value stable prices, they react strongly against the reduce inflation from high rates, as was experienced in New

inflation that eventually emerges, thus switching from one Zealand in the early 1990s.

spending policy direction to another. Deflation (negative inflation) is also damaging to economic

Variable inflation increases uncertainty throughout the growth, as the experience of Japan during the 1990s

economy – including uncertainty about the size and timing illustrates. The main reason for this is that falling prices

of future monetary policy responses.6 Additionally, high cause demand to stall, as consumers delay purchasing

inflation may be volatile and associated with uncertainty goods until some future when prices are expected to be

because it may be caused by a real shock to the economy or even lower. Additionally, because nominal interest rates

by a government losing control of the economy.7 cannot be decreased below zero, under deflation the central
bank cannot reduce the policy interest rate low enough to
Uncertainty impacts on investment, because it makes the
stimulate demand.9
planning of future development more difficult. It increases
the cost of gathering relevant information upon which
sound decisions can be made.8 Firms may therefore delay
The overall impact of inflation
planned investment projects until economic conditions are
From the above, it is clear that there are both redistributive
more stable, or demand a higher nominal rate of return for
and growth costs of inflation (whether inflation is anticipated
those they do undertake. These behaviours in turn impact
or not). It is the poor and those on fixed incomes that suffer
negatively on output growth.
the most from redistributive effects – because the real value

Increased volatility of inflation also reduces the effectiveness of their savings and incomes decline. They lack the financial

of the market by shortening the length of commitments (such resources or knowledge to purchase assets whose prices

as contracts and bank term deposits) to less than would be tend to rise with inflation. Those with higher wealth and

optimal in the absence of such volatility. But, because some disposable income are more able to avoid inflation, by buying

contracts are fixed, people cannot immediately adjust the more sophisticated financial assets or property. They also

length of their existing commitments to the changed optimal have more access to credit and therefore stand to benefit

length. Thus, sudden inflation exacerbates the rigidity or from the reduced real value of debt if inflation increases

inefficiency in the market presented by fixed contracts. unexpectedly. These inflation avoidance activities therefore
tend to accentuate the unequal burden of inflation on the
High inflation has a tendency to become persistent through
poor and less well educated. They also divert resources from
the wage-price spiral and through inflation expectations.
productive investment.
Firstly, in wage-setting, negotiators take account of the
general rise in prices and demand at least as much an increase, 9
Equally, a rate of inflation of between 0 and 1 percent
thus putting up firms’ costs, which firms then pass through is a potential source of risk to an economy. Such a
low rate can easily turn negative. There is also an
upward bias in inflation statistics – thus an economy
5
Friedman (1977), p.466. could actually be experiencing the negative effects of
6
Ball (1992), p.371. deflation when the official inflation rate is positive,
7
Fischer (1994), p.276. but less than 1 percent (Fischer (1994), p 284).
8
Greville and Reddell (1990).

28 Reserve Bank of New Zealand: Bulletin, Vol. 71, No. 3, September 2008
The mechanisms through which inflation affects economic The answer matters for whether the person should invest. A
activity and growth are less clear. While the costs to firms of wrong decision will be costly to the individual, but also costly
changing prices and the costs of holding cash balances are to economic growth as a whole, because of the incorrect
easy to understand, they do not constitute a major cost to resource allocation.
economic activity. However, the distortion of relative price
signals that results from inflation has a far greater impact on
the economy, because it can reduce economic growth.

Relative prices are important because firms and individuals 3 Inflation in recent historical
make decisions on what to produce and purchase, based on perspective
the prices they observe. For example, an increase in demand The evidence that inflation impacts negatively on economic
for a good tends to cause an increase in its price, relative growth is now well accepted by economists and policy-
to the prices of other goods. Observing the price increase, makers. In this section, we illustrate by looking at the inflation
firms have an incentive to produce more of the good. In and growth record of New Zealand and other countries. A
turn, these firms will demand more of the inputs needed to caveat to this exercise is that there are many determinants to
produce the good. The outcome of this process is an efficient growth (apart from inflation), and making inferences about
re-allocation of the economy’s resources towards producing causality requires more sophisticated econometric analysis –
what is needed in the economy, as signalled by the movement which we discuss in the next section.
in relative prices. The re-allocation is necessary for economic
The activity and inflation profiles of industrialised countries
growth. If there is inflation, relative price movements are
during the past 60 years, since the end of World War II, can
distorted or obscured, impeding growth.
be broadly divided into four periods, below.
Inflation can distort relative prices because the prices of
The New Zealand data (figure 1, overleaf) is generally in
individual goods tend not to rise in a uniform manner when
line with this categorisation. The most striking feature of
there is inflation. Individual firms increase prices at different
the inflation profile is the high and highly volatile inflation
times. As a result, under inflation, some of the relative price
during the 1970s and early 1980s compared with the lower
movements that occur will no longer be consistent with
inflation before and after. We see that this period of high
signalling the efficient allocation of resources.
inflation is associated with lower growth than during the
Inflation obscures relative price movements by making it less 1960s, when inflation was lower. Since the early 1990s,
clear to decision-makers whether an increase in the price of New Zealand has experienced low inflation – due to the
a good is a change in its relative price or part of the general commitment of the central bank to price stability, and to
increase in prices. For example, an individual who is looking favourable global conditions (principally, the emergence of
to invest might see certain prices increasing. Does the price Asia as a major exporter of cheap manufactured goods).
rise represent a relative price movement in the industry the During this period, average GDP growth has risen.
investor is looking at, or just a general inflation adjustment?

Period Economic activity Inflation

1. 1950s and 1960s rapid growth moderate inflation

2. 1970 to mid-1980s slower, volatile growth high inflation

3. 1990 to 2007 sustained moderate growth low inflation

4. 2007 to present slowing activity rising inflation

Reserve Bank of New Zealand: Bulletin, Vol. 71, No. 3, September 2008 29
Figure 1 Figure 2
Inflation and GDP growth in New Zealand: United States
% %
1960 – present 15 15

% %
20 20
CPI inflation

10 10
15 CPI inflation 15

10 10 5 5

5 5

0 0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
0 0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 % %
8 8
GDP growth
% %
6 6

5 5 4 4

2 2

0 0
0 0

GDP growth
-2 -2
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

-5 -5
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Figure 3
Horizontal lines indicate average levels for each decade.
United Kingdom
% %
30 30
Graphs for the US, the UK and Australia (figures 2-4) show
similar profiles for inflation as that for New Zealand, with 25 25
CPI inflation
much higher rates during the 1970s and 1980s. Likewise,
20 20
these countries experienced declines in GDP growth during
15 15
the 1970s and 1980s relative to levels of the 1960s. However,
they do not display an obvious increase in GDP growth from 10 10

the 1990s (except for the US in the current decade) as we

5 5

might expect on the basis of the theoretical considerations

0 0
discussed earlier. 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

% %
Overall, a casual observation of these inflation and activity 8 8

profiles supports the theory that high inflation is associated GDP growth
6 6
with low GDP growth. Japan from 1990 to 2007 illustrates
4 4
the phenomenon that deflation is also harmful to growth
(figure 5). When the US and other industrialised countries 2 2

were experiencing prolonged growth in output and

0 0
low inflation, Japan was suffering from deflation and a
-2 -2
contraction in activity that followed the bursting of housing
and stock market asset price bubbles. -4 -4
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

30 Reserve Bank of New Zealand: Bulletin, Vol. 71, No. 3, September 2008
Figure 4 4 Summary of the empirical
Australia
literature
% %
20 20
In the previous section, we looked at the inflation and
CPI inflation
GDP growth experiences of a number of countries. The
15 15
determinants of GDP growth, though, are more complex
10 10 than the inflation rate alone. In this section, we outline the
main complexities in the inflation-growth relationship before
5 5
summarising the findings of empirical studies that have

0 0 tested whether there is a negative relationship between

inflation and economic growth, taking account of these
-5 -5
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 other factors.

% % There is the issue of causation. High rates of inflation tend

8 8
GDP growth
to be associated with lower growth, as the empirical studies
6 6
show us. But does inflation cause lower growth? Or are there
4 4 other common factors influencing both? High inflation may

2 2 be associated with low economic growth because both are

the result of government policies that are damaging to the
0 0
economy. High inflation may therefore be a symptom of bad
-2 -2
economic management – an indicator that the government

-4 -4 is running a set of policies inconsistent with sustained

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
economic growth.10
Figure 5
Other common factors could be driving the negative
Japan
relationship between inflation and growth. While improved
% %
25 25
monetary policy is recognised to have made a considerable
CPI inflation
20 20
contribution to the ‘Great Moderation’ (the period since the

15 15 mid-1980s, during which lower, more stable inflation has

occurred with higher, less volatile growth), other factors
10 10
may have been just as important. These include changes in
5 5
the structural features of the economy (such as improved

0 0 business practices, technology, and financial innovation) and

good luck (favourable economic shocks – such as the lower
-5 -5
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 prices of consumer goods imported from Asia).11

% %
15 15 The general consensus from the empirical studies is that
GDP growth
growth is significantly and negatively related to inflation.

10 10 However, the relationship between inflation and growth is

different for different rates of inflation. At very low positive

5 5 rates of inflation, the growth rate seems to be independent

of inflation, while higher rates of inflation (and negative
0 0 inflation) significantly damage growth. It is now generally

-5 -5
10
Fischer (1993), p.487.
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
11
Bernanke (2004) and Ferguson (2006).

Reserve Bank of New Zealand: Bulletin, Vol. 71, No. 3, September 2008 31
accepted that the threshold level of inflation for industrialised industrialised countries were generally in line with the
countries is in the low single digits, while that for developing theory. The high inflation during the 1970s and early 1980s
countries is higher. was associated with lower and more volatile growth than
in previous decades, while lower inflation since then has
Early studies assumed a linear relationship (that is, that an
occurred during a prolonged period of expansion. However,
increase in inflation of a certain amount would have the same
we recognise that there are many determinants of growth
effect on growth at all levels of inflation). Fischer (1993) was
apart from inflation.
among the first to investigate a non-linear relationship – that
different levels of inflation (above a certain threshold level of Recent empirical studies that investigate the inflation-growth
inflation) impact differently on growth. Arbitrarily choosing relationship have focused on estimating the levels of inflation
a threshold rate of 15 percent inflation, he found that for at which the impact of inflation on growth changes. There is
positive rates of inflation below 15 percent, an increase now general agreement that for industrialised countries this
in inflation is associated with an increase in growth, while threshold is about 3 percent, while for developing countries
above 15 percent, an increase in inflation is associated with it is around 11 to 12 percent.
a reduction in growth.

Subsequent studies have focused on estimating formally the

level at which the impact of inflation on growth changes,
by using more sophisticated econometric techniques.12 An References
influential paper by Khan and Senhadji (2001) estimated Ball, L (1992) ‘Why does high inflation raise inflation
the threshold levels at which inflation impacts negatively uncertainty?’, Journal of Monetary Economics Vol. 29, pp.
on growth as between 1 and 3 percent for industrialised 371-388.
countries, and 11 and 12 percent for developing countries.
Bernanke, B (2004) ‘The great moderation’ Remarks at the
Subsequent studies have confirmed their finding.13
meetings of the Eastern Economic Association, Washington
The findings of this research support central bankers’ goal D.C., February 20, 2004.
of maintaining low levels of inflation (in low single digits for
Bernanke, B, T Laubach, F Mishkin and A Posen (1999)
industrialised countries, and at least close to single digits for
Inflation targeting: lessons from the international experience,
developing countries) – and that doing so is conducive to
Princeton: Princeton University Press.
improved economic performance.14
Briault, C (1995) ‘The costs of inflation’, Bank of England
Bulletin February, pp. 33-45.

Brook, A-M, Ö Karagedikli and D Scrimgeour (2002) ‘An

optimal inflation target for New Zealand: lessons from the
5 Conclusion
literature’, Reserve Bank of New Zealand Bulletin 65 (3), pp.
It is well recognised that high and volatile inflation is
5-16.
detrimental to economic growth. In this paper, we have
outlined the theoretical arguments why this is so, noting Drukker, D, P Gomis-Porqueras and P Hernandez-Verme
that both anticipated and unanticipated inflation have costs (2005) ‘Threshold effects in the relationship between inflation
in terms of redistribution and their impact on activity and and growth: a new panel data approach’, 11th International
growth. Conference on Panel Data, http://www.uh.edu/~cmurray/
TCE/papers/Drukker.pdf
In considering the evidence, we noted that the inflation-
growth experiences of New Zealand and some other Ferguson, RW (2006) ‘Monetary credibility, inflation, and
12
Brook et al. (2002) summarises this literature. economic growth’, Cato Journal 26 (2), Spring/Summer, pp.
13
For example, Drukker et al. (2005).
223-230.
14
Khan and Senhadji (2001, p. 20).

32 Reserve Bank of New Zealand: Bulletin, Vol. 71, No. 3, September 2008
Fischer, S (1993) ‘The role of macroeconomic factors in Greville, R and M Reddell (1990), ‘The costs of inflation’,
growth’, Journal of Monetary Economics 32, pp. 485-512. Reserve Bank of New Zealand Bulletin 53 (1), pp. 37-51.

Fischer, S (1994) ‘Modern central banking’ in Capie, F, Johnson, S (1993), ‘The costs of inflation revisited’, Reserve
C Goodhart, S Fischer and N Schnadt (eds) The future of Bank of New Zealand Bulletin 56 (1), pp. 3-31.
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Reserve Bank of New Zealand: Bulletin, Vol. 71, No. 3, September 2008 33