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April 1, 1991

Federal Reserve Bank of Cleveland

Defending Zero Inflation:
All For Naught
by W. Lee Hoskins

'uring the past several years, I have
spent a considerable amount of time promoting price stability as the overriding
objective for the Federal Reserve System. In this Economic Commentary, I
would like to discuss some of the criticisms that this position has generated, to
respond to those criticisms, and to comment on a conference that the Federal
Reserve Bank of Cleveland held last
year on the subject of price stability.
Briefly put, my advocacy of price
stability stems from three deeply held
beliefs. The first is that a central bank
can, over time, control the price level
of goods and services denominated in
its own currency, but it cannot control
the growth of output (potential or
actual). The second is that a credible
commitment to an inflation objective
enables a central bank to promote economic efficiency and growth (potential
and actual). And the third is that pricelevel stability, popularly called zero inflation, is superior to inflation-rate
Among economists, support for my
first assertion is nearly universal.
There is also widespread agreement on
the second point. I find it is the last
proposition that is most contentious,
particularly when people attempt to
compare the costs of achieving price
stability to the costs of stabilizing the
inflation rate at the status quo.

ISSN 0428-1276

Perhaps the best place to begin is to
call your attention to the Summer 1990
issue of the Federal Reserve Bank of
Minneapolis' Quarterly Review, which
contains an article entitled "Deflating
the Case for Zero Inflation." The essay,
by Rao Aiyagari, is well written and
summarizes some common opinions
about the costs and benefits of stabilizing the price level. The author has performed a valuable service by reviewing
a portion of the relevant literature on
this subject, and through referencing
his work, I am also responding to
criticisms I hear from many others.
Aiyagari concludes that the benefits of
being at zero inflation are small compared to the costs of getting there, and
that most of the costs associated with
nonzero average rates of inflation can
be adequately addressed by adopting institutional changes that do not require
specific inflation targets. I think his
conclusions are unwarranted. And, as
much as I like his article, I believe that
if it is not read carefully it could give
the false impression that economists
have already decided that the costs of
achieving price stability exceed the
benefits that would result.
• The Critics' Framework
There are two dimensions to my critics'
argument that the cost of pursuing a
zero-inflation target would outweigh
the benefits of reaching that target. The
first is that the advantages of achieving
zero inflation are small. The second

Critics of zero inflation believe that
the Federal Reserve System should
target some other inflation rate, since,
in their view, the benefits of achieving
zero inflation would be outweighed by
the costs of getting there. In a recent
speech, Federal Reserve Bank of
Cleveland President W. Lee Hoskins
defended his continuing advocacy of
zero inflation as the System's overriding objective.

deals with the costs of moving from a 5
percent trend rate of inflation to a zeroinflation world. This is the transitioncost argument, which essentially says
that even if zero is the place to be, getting there is not worth the ride.
Typically, the economic models that
are used to do optimal inflation analysis have few, if any, real-world frictions. Markets are assumed to clear
continuously and costlessly, information is free, and expectations — if they
play any role at all — are rational.
Money has few effects on the real
economy in such a world, so it is not
surprising that the benefits of zero inflation in this scenario are small. People
merely plan on the nominal values of
transactions changing predictably over
time. If money doesn't matter much for
the performance of the nonfinancial
economy, then what the monetary
authorities do to money is of little importance.
Last November, we held a conference
at the Federal Reserve Bank of Cleveland that brought together several economists to examine the state of the art in
this area.1 Using some sophisticated
techniques, participants presented
analyses of the optimal rate of inflation
under a variety of assumptions about
the tax environment. Some addressed
the optimal inflation issue explicitly,
some only implicitly.
Based on the papers presented, I think
it is fair to say that our profession has
yet to deliver a compelling theoretical
treatment of the optimal rate of inflation that deserves to be embraced as
the new conventional wisdom. This is
not particularly surprising. Economic
understanding progresses through intellectual competition among alternative,
stylized models. Often, it takes a great
deal of time before these models yield
results that are immediately useful for
policy analysis.
• Inflation and Taxation
One "friction" that economists often
take into account when considering
how society might benefit from zero inflation is the role of the tax system. An

early contribution to the optimal inflation literature was written by Milton
Friedman, who in 1969 presented an
analysis showing that the optimal inflation rate is negative (equal to minus the
real interest rate).2 In 1973,Phelps
modified Friedman's analysis and argued that if the government had only
welfare-distorting taxes at its disposal,
then the optimal inflation rate might be
positive after all.' The intuition for
this result is straightforward: The optimal inflation tax should be such that
the marginal welfare cost of revenue
raised by inflation equals the marginal
welfare cost of revenue raised from
other sources.
The Friedman and Phelps analyses of
inflation as part of an optimal taxation
system sparked a literature that is still
growing strongly today. For example, a
paper presented by Hansen and Cooley
at our price stability conference concludes that the inflation tax is less burdensome than either capital or labor
taxes. But their results are based on the
peculiar assumption that the effective
capital tax rate at 5 percent inflation
does not change when the inflation rate
becomes zero. This is an assumption
that surely underestimates inflation's
deleterious effect on the capital stock.
Another presentation, by Chari, Christiano, and Kehoe, shows that the Friedman rule holds even in the presence of
distorting taxes: The best monetary policy yields an inflation rate equal to
minus the real rate of interest. In their
model, the optimal inflation rate has a
large variance around its trend (about
20 percent) because it is desirable for
the government to use its fixed nominal
debt, in conjunction with variable inflation, to generate changes in the real burden of its debt over the business cycle.
Another conference participant,
Lawrence Summers, predicts that the
optimal taxation literature will teach us
nothing useful about the optimal inflation rate. He argues that seignorage is
simply not an important revenue
source, and that the public cares about
inflation for other reasons.

The interaction between inflation and
our current tax system, especially as it
applies to income generated by capital,
represents one of the more significant
channels through which nonzero inflation can exact economic costs. This
channel of distortion is often not taken
seriously, because people think that its
effects are minimal or that it would be
easy to index the tax system. For example, Aiyagari claims that the superior
solution would be a change in the tax
system, not a change in our monetary
policy goals. Correcting the tax code is
a good idea, of course, but until that
happens, what possible excuse is there
for not letting the monetary authorities
do what is necessary to improve social
It is clear that our horrendous inflationary experiences in the 1970s and early
1980s induced the limited inflation indexation of the current tax system.
However, the job is far from complete.
Capital gains, corporate depreciation
and interest expenses, and personal
interest income remain untouched by
efforts to index the tax system for inflation. Complete indexation of the tax
code, however desirable it may be, will
be extremely difficult to achieve. For
example, even the bracket indexation
implemented by recent tax reform does
not fully protect taxpayers from "bracket creep" (nonlegi slated increases in
marginal tax rates created by positive
Will another inflationary experience
like that of the 1970s be required to induce further progress on tax indexation? I fail to understand why some
feel that these inflation/tax interactions
are a significant drag on the economy,
yet argue that only Congress should be
concerned with the problem. The problem exists because of the interactions
between inflation and a tax system
based in current dollars. Therefore, it
seems to me that the responsibility for
minimizing these costs lies as much
with the monetary authorities as with
Congress. Doesn't it make more sense
for monetary authorities to try to correct the inflation part of the problem,
rather than simply to hope that Con-

gress will implement changes that it
may be unable or unwilling to pursue?
• Drifting in Uncertain Waters
Another area of concern is the role of
uncertainty as a source of inflation costs.
How important are the price system distortions that arise from uncertain inflation? There is a class of models — the
market-clearing, imperfect-information
paradigm associated with Robert Lucas
and others — in which inflation uncertainty harms the economy by distorting
the period-to-period relative price signals that facilitate the efficient allocation of scarce resources.
Despite the pervasive intellectual influence exerted by the Lucas framework
to this day, the empirical evidence accumulated since the development of the
paradigm in the early 1970s has not
been entirely supportive. This point is
not lost on critics, who think that the
lack of evidence on short-term distortions should persuade us that inflation
uncertainty is simply not that important
to social welfare.
But surely the relative-price/aggregateprice confusion stressed by the Lucastype models is a special type of uncertainty. The failure to find significant
effects arising from uncertainty that is
resolved within a few quarters tells us
next to nothing about the type of longrun uncertainty with which the zeroinflation position has always been fundamentally concerned.
Indeed, Laurence Ball and Stephen
Cecchetti demonstrate that it is precisely the uncertainty occurring over
extended time horizons that is most
affected by the average inflation rate.
This is one reason why I favor a pricelevel target. An inflation-rate target
enables the price level to drift without
bound, and with no enforcement mechanism to ensure that inflation "mistakes"
will be corrected, the long-run variance
of the price level is infinite.

Concern about this longer-term uncertainty is essentially what Lawrence
Summers stressed at our November conference. From his viewpoint, inflation is
important because money is an intertemporal standard of value. When people
have reason to believe that this standard
will erode over time, they invest numerous resources to protect themselves.
Those who have nominal debt outstanding will drag their feet in paying it back,
while creditors will invest in ways to
accelerate the collection of funds. The
private gains to self-protection are clear,
as are the social costs.
Recent experience is the best testimony
to the real resource cost of inflation.
During the 1970s, people could see
that inflation accelerated with each
passing year. They guessed, reasonably
at the time, that financial assets were of
limited value in protecting their wealth
from the inflation tax. Consequently,
farm land, commercial and residential
property, and precious metals became
much more expensive as people sought
to shelter their wealth. Not only was
time spent seeking out these investments, which was socially wasteful,
but the resource misallocation itself
resulted in a much greater waste of
land, labor, and capital that society is
still paying for today.
It is difficult to comprehend how efficient planning within the public and
private sectors could not be inhibited
by this type of long-run uncertainty.
Furthermore, the intuition that long-run
inflation uncertainty is costly has empirical support: In cross-country comparisons, the variability of inflation
tends to be negatively related to economic growth. I find that the case for
reducing price-level uncertainty is far
more compelling than a cursory analysis might indicate.
• Transition Costs
In evaluating the costs of getting to zero
inflation, economists almost always use
models in which markets do not clear,
or do not clear without cost. Gone is the
market-clearing, flexible price, rational
expectations model. In its place is a
model with price contracts that make

the transition to zero extremely costly.
The source of the friction is usually not
entirely explicit, but the implication is
that we must assume some frictions. It
is these frictions, coupled with the inability of markets to clear, that make
ending inflation so costly.
But isn't it sensible to assume that the
implicit sources of frictions that make
lowering the inflation rate costly would
also contribute to making inflation costly in and of itself? For instance, a variety of explicit and implicit nominal
contracts already exist among people,
and a transition to zero inflation could
alter the real values of payments from
those originally intended. But surely
the entire institutional apparatus that
generates these contracts must involve
resource costs that are positively related to the average rate of inflation.
One should not compare the costs of
getting to zero inflation in non-marketclearing models, where such costs are
high, to the benefits of being at zero inflation in frictionless, continuously
clearing models, where the benefits are
low. If we are going to use a model
with frictions to measure the cost of
getting to zero inflation, then we should
also use such a model to examine the
benefits of being there. This is one
reason I am skeptical of so many "costbenefit" estimates of reducing inflation, including Aiyagari's.
I am also skeptical about transition cost
estimates that do not account for the
possibility that a price stability objective will be regarded as credible by the
public. Economic theory and reasonable model simulations persuade me
that with credible precommitment, a
central bank can greatly minimize
private-sector planning errors during
the transition period. I think that much
of the disagreement among economists
on the size of transition costs revolves
around the ability of a central bank to
credibly commit itself to achieving its

• Conclusion
History suggests that economic performance is not very good in countries that
try to deal with inflation through government indexation of the tax code,
transfer payments, bank accounts, and
other nominal transactions. At the same
time, private contracting arrangements
in these and other countries never seem
to go far enough in protecting people,
presumably because of the costs associated with implementing and maintaining the process. People do not like inflation, and when it becomes high enough
for long enough, they demand that it
end. From a political point of view, perhaps a 5 percent inflation rate could be
tolerated forever in the United States.
Not long ago, however, this nation
resorted to wage and price controls to
combat an inflation rate of 4 percent.
Economists must think about inflation
scientifically. They should want to
know how inflation, even at 5 percent,
affects resource allocation and social
welfare. This is the spirit in which Rao
Aiyagari frames his analysis. I think
that economists are just beginning to
undertake the truly hard work of modeling the effects of inflation on economic
welfare, and what little we do know
about these effects indicates to me just
how much more work lies ahead. One
direction that seems particularly worth
pursuing is modeling the resource costs

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of coping with the intertemporal uncertainty about the value of money.
I am pleased that our price stability conference sparked as much interest as it
did within the academic community.
The Federal Reserve Bank of Cleveland will sponsor another such conference in a year or two to see how
much progress has been made on some
of these topics. Until I see some hard
evidence to dissuade me, I plan to continue my advocacy of price stability as
the overriding objective of the Federal
• Footnotes
1. See William T. Gavin, ed, Price
Stability, a special issue of the Journal of
Money, Credit and Banking, vol. 23, no. 2,
part 2. Columbus: Ohio State University
Press, 1991 (forthcoming).
2. See Milton Friedman, The Optimum
Quantity of Money and Other Essays.
Chicago: Aldine Publishing Co., 1969.

5. See David Altig and Charles T. Carlstrom, "Inflation and the Personal Tax Code:
Assessing Indexation," Federal Reserve
Bank of Cleveland, Working Paper 9006,
July 1990.
6. See Robert E. Lucas, Jr., "Expectations
and the Neutrality of Money," Journal of
Economic Theory, vol. 4 (April 1972), pp.
7. See Laurence Ball and Stephen G. Cecchetti, "Inflation and Uncertainty at Long
and Short Horizons," Brookings Papers on
Economic Activity, vol. 1 (1990), pp. 215-54.
8. See Kevin B. Grier and Gordon Tullock,
"An Empirical Analysis of Cross-National
Economic Growth, 1951-80," Journal of
Monetary Economics, vol. 24 (September
1989), pp. 259-76. See also footnote 4.

W. Lee Hoskins is president of the Federal
Reserve Bank of Cleveland. The material in
this Economic Commentary is based on a
speech presented to the Eastern Economic
Association in Pittsburgh on March 16,1991.

3. See Edmond S. Phelps, "Inflation in the
Theory of Public Finance," Swedish Journal
of Economics, vol. 75 (March 1973), pp.
4. David E. Lebow, John M. Roberts, and
David J. Stockton make the same point in
"Economic Performance under Price Stability," unpublished manuscript, Board of
Governors of the Federal Reserve System,
December 1990.

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