Full text of Economic Commentary (Federal Reserve Bank of Cleveland) : The Case for Zero Inflation, September 15, 1988

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September

• Conclusion
For all of these reasons,
consensus that produces
inflation - particularly
ciated with a price-level

•
a political
a goal of zero
if it is assotarget and

the associated reversals of unexpected
price-level changes - is more likely
to be stable and to produce more certainty about future inflation than is a
consensus that chooses a positive
inflation rate at any particular level.
Evidence supports the conclusion
that "the welfare costs of high inflation, even if the inflation is expected,
are large in the current United States
economy" (emphasis added)."
The elimination of inflation is likely
to have greater short-term costs, such
as more short-term uncertainty, than
does the maintenance of a relatively
stable inflation at current levels.
These costs must be weighed against
the gains from the elimination of
long-term inflation. There are good
reasons to believe that the benefit-tocost ratio for achieving this social
objective is high enough to warrant
its pursuit.

Footnotes

1. For a discussion of these costs, see Milton Friedman, "The Resource Cost of Irredeemable Paper Money," journal of Political Economy, vol. 94, no. 3 (June 1986),
pp. 642-647.
2. See Stanley Fischer, "Towards an
Understanding of the Costs of Inflation:
ll," in Karl Brunner and Allan H. Meltzer,
eds., The Costs and Consequences of Inflation, Carnegie-Rochester Conference Series on Public Policy, Amsterdam: NorthHolland Publishing Company, vol. 15
(1981), pp. 5·41.

3. See Alan]. Auerbach, "Inflation and the
Choice o(Asset Life," journal of Political
Economy, vol. 87, no. 3 (June 1979), pp.
621-638
4. See the empirical study of long-run
growth rates in 47 countries by Roger
Kormendi and Philip G. Meguire, "Macroeconomic Determinants of Growth: CrossCountry Evidence," journal of Monetary
Economics, vol. 16, no. 2 (September
1985), pp. 141-63
Theoretical models that reach these
conclusions include Robert ). Barro, "A
Capital Market in an Equilibrium Business
Cycle Model," Econometrica, vol. 48, no. 6
(September 1980), pp. 1393-1417; Angelo
Mascaro and Allan H. Meltzer, "Long and
Shan-term Interest Rates in a Risky
World," journal of Monetary Economics,
vol. 12, no. 4 (November 1983), pp. 485518; and Alan C. Stockman, "Anticipated
Inflation and the Capital Stock in a Cashin-Advance Economy," Journal of Monetary Economics, vol. 8, no. 3 (November
1981), pp. 387-393.

eCONOMIC
COMMeNTORY

In addition to the empirical evidence
cited above, recent simulations by Marianne Baxter suggest that these effects may
be quite large. See "Approximating Suboptimal Dynamic Equilibria: An Euler Equation Approach," Working Paper No. 139,
Rochester Center for Economic Research,
University of Rochester, April 1988.

5. While economists generally consider
liquidity costs of inflation to be minor, a
recent study by Thomas F. Cooley and
Gary D. Hansen estimates that the welfare
cost of reduced liquidity resulting from a
sustained 10 percent inflation is between
0.1 and 0.4 percent of GNP. See "The Inflation Tax and the Business Cycle," manuscript, University of Rochester, July 1988.

Federal Reserve Bank of Cleveland

___

The Case for
Zero Inflation
by William T. Gavin and Alan C. Stockman

6. See Fischer (1981), p. 36.

William T Gat-in is an economic adrisor
at the Federal Reserue Bank of Cleueiand.
Alan C Stockman is an associate professor
of economics at tbe Unicersity of Rochester. Tbis article uias uritten ubtte be u-as a
uisiting scbolar at tbe Federal Resene
Bank of Clereland.
Tbe tieu« stated herein are those of tbe
autbors and not necessarilv those of tbe
Federal Resene Bank of Clereland or of
tbe Board of Gouernors of tbe Federal
Reserve System.

Few people claim to like inflation.
Yet few people can intelligently
explain why they dislike it. Even
economists frequently find it hard to
explain-why inflation is bad, especially if the inflation is fully
anticipated.
Indeed, some economists argue that a
low level of inflation is desirable.
Others argue that inflation would be
eliminated in an ideal world but that
the short-run costs of eliminating
inflation are so high that the Federal
Reserve's monetary policy should aim
instead at maintaining the current
level of inflation or at achieving some
other goal.

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

Federal Reserve Bank of Cleveland
Research Department
PO. Box 6387

This Economic Commentary contends that monetary policy should
aim at completely eliminating longrun inflation. We specifically explain
how society could benefit if monetary
policy were directed toward producing a stable price level, making temporary any unforeseen deviations
from this long-run target.

Cleveland, OH 44101

Material may be reprinted provided that
the source is credited. Please send copies
of reprinted materials to the editor.
Address Correction Requested:
Please send corrected mailing label to the Federal Reserve Bank of Cleveland, Research Department,

15, 1988

Po. Box 6387, Cleveland, OH 44101
ISSN 042R-1276

• Inflation Distorts Nominal Prices
Inflation adds "noise," or distortion,
to nominal prices. People must tax
their memories and powers of calculation to compare prices of goods at
different periods of time. Difficulties
with accurate price comparisons lead
to economic inefficiencies. Inflation
thereby limits the economic opportunities for our society.
This problem is particularly severe
when inflation is highly variable or
highly unpredictable. Unpredictable
inflation causes inefficiencies because
people find it difficult to tell whether
a price is high because of inflation or
for some other reason, such as high
demand or scarce supply. Variable
inflation, even if predictable, complicates the calculations that people
must make to compare prices at different times.
This cost of inflation is important
even for low rates of inflation,
because the costs of accurately performing these calculations do not
depend very much on the level of
inflation. When long-term inflation is

The authors argue that a monetary
policy of zero inflation would benefit
society by eliminating price distortion, increasing economic growth,
adding liquidity to the economy, and
reducing uncertainty associated with
price-level drift.

eliminated and the price level is stabilized, however, people no longer
need to perform these calculations.
Inefficiencies are reduced, and economic opportunities are maximized.
•

Inflation Leads to Socially

Inefficient Institutions
Inflation creates potential financial
losses for holders of money and other
assets denominated in dollars. To
avoid these private losses, markets
adjust by creating financial institutions and instruments that would be
unprofitable in the absence of inflation. An obvious example is the

financial "advice" industry that is
concerned with protecting investments from inflation risk
Specificmarkets have been created to
trade futures contracts in foreign
exchange and interest rates. There
was also a brief period in which the
financial market traded
government's reported
Consumer Price Index.
folded as the inflation
in the ] 980s_1

futures in the
level of the
This market
rate declined

The creation and maintenance of
these institutions is socially inefficient. The resources used in them
could be better devoted to creating
products and services that people
desire in an environment of zero
inflation. The costs incurred in minimizing private losses from inflation
are greatest when inflation is very
high or very unpredictable, But
important costs may still be present
even at low and stable inflation rates.
• Inflation Is Costly When
It Interacts with the Tax System
Inflation raises economic distortions
associated with the existing tax system because taxes on the return to
capital are not adjusted for inflation, A
recent study estimated that the cost of
10 percent inflation from this source
alone is (as a rough order of magnitude) about 0_7 percent of gross
national product (GNP) each year,
and possibly as high as 2 to 3 percent
of GNP each year.!
In addition, inflation raises other
economic distortions by interacting
with the current tax system to alter
the allocation of capital across sectors
of the economy, the debt/equiry mix
chosen by firms, and the choice of
asset life. For example, nominal
interest payments are tax-deductible;
thus inflation raises the value of the
deduction relative to the real cost of
housing, giving people an incentive
to overinvest in housing.

A similar effect leads firms to acquire
more debt rather than to issue new
stock when faced with a need for new
funds, Also, depreciation allowances
are not indexed for inflation, leading
firms to prefer longer-lived assets during periods of inflation.' These costs
of inflation could be reduced by
appropriate changes in the tax system. But, in the absence of tax
changes, the distortions represent
important costs even to low, stable,
and fully anticipated inflation.
• Inflation Reduces
Economic Growth
Positive inflation may have adverse
effects on economic growth, The longterm growth rate of an economy is
mainly determined by factors having
little to do with monetary policy, such
as the rate of technological innovation, But government policies can also
affect the rate of economic growth,
Evidence from a large set of countries, with very different institutions
and economic conditions, supports
the conclusions some theoretical
economic models have reached: that
long-term economic growth is
reduced by inflation and by greater
variation in the growth rates of the
money supply.'
This negative effect of inflation on
long-term growth may reflect a variery
of channels, including adverse effects
of inflation on capital formation
(either directly or through interactions with the tax system), effects on
the use of scarce resources to form
socially inefficient institutions, and
effects from the distortion introduced
into the price system by inflation; or
it may reflect various other channels,
Whichever of these channels is most
important, the evidence indicates that
the reduction in the economic
growth rate associated with higher
inflation is large and pervasive,

Sometimes it is argued that eliminating inflation is undesirable because
policymakers can use inflation to try
to reduce unemployment
in the short
run, The theoretical basis for such a
policy, and the evidence on whether
it can work, is weak But even granting that more inflation could lead to a
temporary increase in employment,
the reduction in long-term economic
growth associated with inflation
probably outweighs any short-run
gains by so much that these short-run
considerations should play little role
in policy formation,
• Zero Inflation Adds liquidity
to the Economy
The elimination of inflation would
give people the incentive to hold
what Milton Friedman has called the
optimal quantity of money, People
derive benefits from holding various
forms of money, facilitating trade and
serving as a temporary store of val ue.
Inflation, by acting as a "tax" on holdings of currency and other noninterest-bearing forms of money,
reduces the real quanriry of these
assets, Valuable resources are wasted
as people attempt to conserve their
money balances, and the resulting
lower level of liquidiry reduces the
benefits that people receive from
holding money,
This liquidity cost of inflation is the
cost traditionally emphasized in discu sions of inflation, It is only one of
many costs of inflation, however, and
probably one of the less important."
•

Inflation Creates Uncertainry

For reasons that are not well understood, higher levels of inflation have
rypically been associated with greater
variabiliry of inflation, and so greater
uncertainry about inflation,
To this point, our arguments have not
relied on whether inflation was
expected or unexpected, There are,
however, many adverse effects associated mainly with unanticipated
inflation, Perhaps the most important
of these is the misallocation

resources associated with forecasting
real interest rates, Just as with
expected inflation, unexpected inflation may be directly responsible for
lower investment, for the creation of
SOCiallywasteful institutions, and for
lower rates of economic growth,
Even though it may be possible to
have a low and stable positive rate of
inflation over some period of time,
the existence of inflation continues to
create uncertainty. Little or nothing in
historical experience suggests that a
low inflation rate can be maintained
for long at a stable level. As a consequence, there is little reason for people to expect it.
Any nonzero rate of inflation is in
some sense arbitrary; people will
have greater uncertainry because they
will not understand why inflation is 4
percent, for example, rather than 2
percent or ]6 percent. Zero inflation
is not arbitrary; it corresponds to the
complete elimination of inflation, A
policy aimed at the elimination of
inflation is qualitatively different from
a policy designed to produce inflation at some particular level.
The elimination of long-term inflation
would change the entire tone of discourse about monetary policy, When
policy is aimed at producing inflation,
the relevant political controversies
involve how much inflation should
occur. When policy is aimed at the
elimination of inflation, the controversies will involve whether long-term
inflation should occur. The question
"Is there any long-term inflation?"
logically precedes the question "How
much long-term inflation is there?", If
the answer to the first question is no,
then the second question need not
even be asked,
Many people believe that there is a
trade-off between inflation and some

other goal, such as reduced unemployment, smooth interest rates, or
other sources of government revenue,
By adopting a policy of eliminating
long-term inflation, the Federal
Reserve would make a statement that
it will not attempt to exploit such
tradeoffs.
Inflation creates uncertainry because
people believe that the particular
inflation rate permitted by policymakers, say 5 percent, represents an
attempt to achieve other goals at the
cost of a stable price level. But there
is little reason to expect that policymakers' chosen inflation rate will
remain constant in the face of changing economic or political conditions,
Therefore, people have little reason
to expect any positive level of inflation to remain stable, The result is
greater uncertainry about the future,
• Price-Level Drift
The elimination of long-term inflation
and the elimination of short-term
inflation can be thought of as separate goals that may not be simultaneously achieved, Because policymakers
can control the overall price level
only indirectly through control over
the monetary base, the price level
will sometimes rise or fall even if
policymakers attempt to hold it fixed,
A policy directed only at elimination
of short-term inflation could allow
the price level to drift over time in
response to these unexpected
changes: it could make short-term
expected inflation zero even if the
price level had previously risen or
fallen, As a consequence, over longer
periods of time the price level would
drift up or down.
A policy directed toward elimination
of long-term inflation, on the other
hand, would eliminate this price-level
drift by adopting a price-level target,

Policymakers would, following an
unexpected increase in the price
level, engineer a decrease in the price
level to keep it at the target level.
Consequently, while long-term inflation would be zero, short-term
expected inflation would need not
always be zero,
Other reasons support the argument
that policymakers should eliminate
long-term inflation by stabilizing the
price level. People cannot be sure
whether any increase in the price
level is intended or whether it is the
result of a change in economic conditions that policymakers did not foresee, If the price level rises because of
an unforeseen change in economic
conditions, people may be tempted
to believe that there has been a
change in policymakers' goals, and
that the zero-inflation goal has been
abandoned, By choosing to target the
price level and by quickly moving to
reverse any unforeseen changes in
that level, policymakers would gain
credibiliry and reduce uncertainty.
Long-term price-level drift would
entail greater uncertainry than would
price-level stability. This uncertainry
would result in higher average longterm interest rates, Price-level targeting would, of course, entail variations
in short-term interest rates, as unforeseen price-level changes are expected
to be reversed, But short-run interestrate variation is not likely to be very
important compared to the achievement of lower and more stable longterm rates, Moreover, these variations
in short-term interest rates are not
necessarily bad: they provide Signals
that help firms and consumers make
correct decisions, and they demonstrate the policymakers' continuing
commitment to the goal of a stable
price level.