## The Future of Inflation Part II: How Costly Is Inflation?

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**Canonical URL:** [The Future of Inflation Part II: How Costly Is Inflation?](https://www.imf.org/en/publications/fandd/issues/2022/03/future-of-inflation-partii-agarwal-kimball)

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## Bibliographic details
- Authors: RUCHIR AGARWAL, MILES KIMBALL
- Published: April 12, 2022

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### Overview
- Article examines the costs and benefits of inflation and assesses trade-offs, focusing on single-digit inflation (excluding hyperinflation).
- Highlights disconnect between strong public aversion to inflation and small welfare costs implied by standard neoclassical models.
- Authors: Ruchir Agarwal and Miles Kimball. Published April 7, 2022.

### Inflation costs (theoretical and cognitive)
- Theoretical neoclassical costs typically small; policymakers face three choices: address perceived dislike, modify models, or accept perceived harms as real.
- Main categories economists focus on:
  - Shoe-leather costs:
    - More frequent trips to the bank to avoid the “inflation tax.”
    - Peter Ireland (2009) estimates these costs equal 0.05 percent of annual income for 2 percent inflation.
    - Costs can be higher with market power (Lagos and Wright 2005; Kurlat 2019).
  - Misallocation of resources and menu costs:
    - Price stickiness causes relative-price distortions.
    - Menu-cost literature: Mankiw (1985); Akerlof and Yellen (1985).
    - Costs relatively small but rise with higher inflation.
  - Unpredictability:
    - Friedman (1977) linked higher inflation with higher inflation uncertainty, causing distortions and arbitrary redistribution.
- Cognitive costs (confusion and sentiment) may be the most serious:
  - Real-world information processing is costly; confusion from inflation is hard to quantify but substantial.
  - Examples: blaming inflation for lower-than-desired real wages; tax-code distortions; mistaking nominal for real returns in retirement planning.
  - Shiller (1997) found public perceives inflation as harming standard of living, amplified when price increases are attributed to greedy actors without wage increases.
- Consumer-confidence evidence (1980–2021, six major economies, OECD data):
  - Higher inflation associated with lower consumer confidence across countries.
  - At zero inflation, a 1 percentage point increase in inflation has the same impact on confidence as a 1 percentage point increase in unemployment.
  - Adverse impact is greater at higher inflation levels and is well captured by a quadratic function centered just below zero inflation.
  - Conclusion: even low inflation is perceived as costly and costlier than neoclassical models suggest.

### Inflation benefits
- Two primary benefits that underpin many central banks’ 2 percent target:
  - Reduced risk of hitting the zero lower bound:
    - Zero or negative inflation targets increase the risk of hitting the zero lower bound (ZLB), restricting central bank policy space via lower nominal interest rates.
    - Woodford (2003) conventional models suggest optimal inflation target is zero, but central banks have adopted 2 percent.
    - Real rates have declined over time; central banks have faced the ZLB or effective lower bound for several years (Chart 2 referenced).
    - Central banks respond asymmetrically around the 2 percent target—tolerating inflation below 2 percent but acting as if costs above 2 percent are high (Chart 3 referenced).
  - Overcoming downward wage stickiness:
    - Firms find it harder to cut nominal wages than to raise them; pay cuts may harm morale more than layoffs (Bewley 1999).
    - Higher inflation can facilitate real-wage adjustments via nominal confusion; traced to Keynes (1936).
    - Such adjustments can be beneficial when wages are misaligned with the marginal product of labor.
- Two medium-sized potential benefits:
  - Financial-stability benefits:
    - Higher nominal rates from higher inflation may make it harder for Ponzi schemes, irrational bubbles, and zombie firms to persist.
    - Low nominal rates can hide deterioration in borrowers’ net worth by reducing monthly loan payments relative to income.
  - Antitrust and deregulation effects:
    - Higher inflation may politically encourage price-lowering deregulation and antitrust efforts (historical example: US deregulation in the 1970s).
- Debt-overhang considerations:
  - Inflation can reduce real debt burdens but is a transfer from creditors to debtors, with equal and opposite wealth effects.
  - Net welfare benefits of an “inflation tax” are likely small; better to pursue distributional objectives via fiscal policy.
  - Use of inflation as debt relief raises the risk premium on future debt due to expectations of repeated use.

### Fundamental trade-off and policy scenarios
- Fundamental trade-off: weigh cognitive costs to households against macroeconomic benefits (avoid ZLB and ease wage adjustments).
- Status quo explanation for 2 percent target:
  - Central banks internalize ZLB benefits but households bear cognitive costs, producing tolerance for permanent 2 percent inflation despite household aversion.
  - The 2 percent number is a convention arising from central bank practice rather than an intrinsic macroeconomic law.
- Two possible future scenarios:
  - Scenario 1 — Status quo continues:
    - Alternation between (a) long periods of sluggish growth at the ZLB with inflation below 2 percent, and (b) periods of normal growth away from the ZLB but with cognitively costly average inflation of 2 percent (with occasional spikes above 2 percent).
  - Scenario 2 — Innovation and norm change:
    - Wider recognition that the ZLB and wage stickiness are policy/norm-dependent, not immutable.
    - Innovation in macro tools could “break” the ZLB and evolve toward a modern “share economy” with more flexible labor compensation (e.g., Weitzman’s share-economy idea of annual bonuses).
    - With evolving labor norms (teleworking, gig economy), Weitzman’s proposal merits revival.
    - Authors predict that as macro innovation expands, benefits of positive inflation will fade and inflation will tend toward zero.

### Policy implications and recommendations
- Consider addressing cognitive costs directly (public communication, reducing confusion in taxes and financial contracts).
- Prefer fiscal and structural policies over inflation as a tool for redistribution or debt relief.
- Develop and deploy macro-policy innovations to reduce reliance on positive inflation for avoiding the ZLB:
  - Options to break through the ZLB are available in the literature (Agarwal and Kimball 2015; Agarwal and Kimball 2019).
  - Encourage reforms that increase wage flexibility (e.g., greater share-based or bonus compensation) to reduce need for positive inflation to reallocate real wages.
- Promote policies that target financial stability and antitrust/deregulation directly instead of relying on inflation to produce such outcomes indirectly.

### Key numeric and dated references preserved exactly
- Article published on April 7, 2022.
- Focus on single-digit inflation; hyperinflation excluded from scope.
- Ireland (2009) estimate: 0.05 percent of annual income for 2 percent inflation.
- Consumer-confidence comparison period: 1980 and 2021 across six major economies.
- Illustrative example: yard length question—“This year the yard is 36 inches.”
- Central-bank inflation target referenced: 2 percent.
- References to works dated: 1969 (Friedman), 1977 (Friedman), 1985 (Mankiw; Akerlof and Yellen), 1986 (Weitzman), 1991 (Summers comment), 1997 (Shiller), 1999 (Bewley), 2000 (Lucas), 2003 (Woodford), 2009 (Ireland), 2015 and 2019 (Agarwal, Kimball), 2016 (Mankiw), 2022 (Krugman).

*Summary derived from “The Future of Inflation Part II: How Costly Is Inflation?” by Ruchir Agarwal and Miles Kimball, F&D Magazine, published April 7, 2022.*

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_Source: https://www.imf.org/en/publications/fandd/issues/2022/03/future-of-inflation-partii-agarwal-kimball_