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FRBSF

WEEKLY LETTER

July 20, 1990

The Costs of Anticipated Inflation
/lOur strategy continues to be centered on
moving toward, and ultimately reaching, stable
prices, that is, price levels sufficiently stable so
that expectations of change do not become
major factors in key economic decisions.
Alan Greenspan, in testimony to the House
Committee on Banking, Finance, and Urban
Affairs on January 24, 1989.
II

Inflation can distort economic decision making.
In this regard, it is important to distinguish between the effects of anticipated and unanticipated inflation. Some of the more serious costs
arise from inflation that is not fully anticipated.
As discussed in the Letter of March 2, 1990,
these include arbitrary transfers of wealth between creditors and debtors and difficulty in
distinguishing between absolute price changes
and movements in relative prices. Inflation uncertainty also hampers long-term planning by
business and labor, and increases uncertainty
about the real returns to saving and investment,
thereby reducing economic growth.
In contrast, many argue that when inflation is
fully anticipated, there is little or no cost to the
economy since nominal interest rates will adjust
to maintain real returns. However, with a tax
system that is not indexed to inflation and loan
instruments that generally do not allow households to borrow against anticipated increases in
future income, even anticipated inflation can
have distortionary effects. This Letter discusses
the major effects of anticipated inflation, and
presents some quantitative estimates of these
effects on the allocation of resources in the
economy. These estimates show that even fully
anticipated inflation is significantly non-neutral
in its impact.

u.s.

Anticipated inflation and taxes
Irving Fisher provided the classic analysis of the
effects of anticipated inflation in his Theory of
Interest over a half century ago. Fisher argued
that borrowers and lenders base their decisions
on real interest rates, and that nominal interest
rates adjust to compensate for anticipated infla-

tion. Moreover, in a world in which interest income is taxable and the costs of borrowing are
tax deductible, the Fisherian model suggests that
borrowers and lenders base their decisions on
after-tax real interest rates.
Thus, for example, when the marginal income
tax rate is 50 percent and the equilibrium real
after-tax rate of interest is three percent, the
nominal interest rate will settle at six percent,
assuming anticipated inflation is zero. But if
anticipated inflation rises to five percent, the
nom inal interest rate wi II rise to 16 percent to
give the same real after-tax return of three
percent.
The key insight of the Fisherian model is that
anticipated inflation should have no impact on
the real economy as long as nominal rates adjust
fully to preserve real rates of return. In practice,
however, certain aspects of the
tax code
interact with inflation in such a way that real
rates are affected. First, although the tax code
allows businesses to provide for the replacement
of worn-out capital stock through a depreciation
allowance, it specifies allowable depreciation in
terms of the historical cost of the capital, not its
current replacement cost. Thus, when prices rise
due to inflatioll, the effective tax rate on business
profits also rises because the base for depreciation is not increased accordingly. As a result,
business investment tends to fall relative to other
kinds of spending in an inflationary environment.

u.s.

U.s.

The
tax code also may discourage inventory
investment during inflationary periods. Seventy
percent of
firms value inventories on a firstin, first-out basis (FIFO). When thesefirms sell
goods out of inventory in an inflationary period,
they incur a taxable capital gain since the goods
are sold at inflated prices but are valued for tax
purposes at old, lower prices.

u.s.

LIFO accounting, in which valuation is on a !astin, first-out basis, largely avoids this tax because
the cost of goods sold is measured in terms of
more recent prices. However, it is more complex

FRBSF
than FIFO, and it has the. disadvantage of reducing reported pre-tax profits, something publiclyheld firms may be reluctant to do. To the extent
that firms use the FIFO method, then, anticipated
inflation raises the after-tax cost of holding inventories, which, in turn, may reduce inventory
investment.

model. In the simulation, money growth was
permanently raised by five percentage points,
thus generating a permanent increase in the inflation rate of five percentage points. Nominal
interest rates were allowed to rise by the amount
required to keep the aggregate demand for goods
and services equal to long-run potential output.

Liquidity constraints

The Fisher effect suggests that nominal interest
rates should rise by more than the five-percentage point increase in the anticipated rate of inflation to compensate for both the increase in
inflation and the increased tax liability associated
with the higher nominal interest payments. However, as discussed above, the use of historical
cost depreciation in an inflationary environment
increases the effective tax rate on business profits
and, therefore, raises the real cost of capital for
business. This tends to reduce business borrowing, thereby reducing the upward pressure on
nominal interest rates. Similarly, the inflationrelated increase in liquidity constraints on households tends to depress househoid borrowing,
which further limits the rise in nominal interest
rates.

In addition to the way anticipated inflation
interacts with the tax code to alter real investment decisions, rising nominal interest rates
associated with anticipated inflation tend to
exacerbate liquidity constraints on households.
Even in a noninflationary environment, households may be liquidity constrained in the sense
that they are unable to borrow against rising real
incomes to alter their current spending and
investment patterns.
Anticipated inflation exacerbates this constraint
because it raises nominal interest rates immediately, while increases in household norninal
incomes occur only gradually. Because lenders
are averse to high ratios of current debt service to
current income, households are not able to borrow against the anticipated increases in future
income, making it more difficult for them to
qualify for loans. As a result, borrowing by
households for expenditures on housing and
consumer durables tends to be more sensitive to
nominal after-tax interest rates than to real aftertax rates. And although capital gains on housing
assets are given favorable tax treatment, which
tends to increase the demand for housing when
inflation and nominal interest rates rise, the effect
of liquidity constraints tends to dominate, so that
expenditures on residential investment vary inversely with nominal interest rates.
In contrast, this type of liquidity con:;traint is
less important for businesses. The typical business has both old and new capital stock. When
expected inflation rises, the cashflow (net of debt
service) on the existing capital rises as well, and
offsets the low initial net cashflow on new capital
investment. As a result, business borrowing tends
to respond more to real interest rates than to
nominal interest rates.

Estimating the costs
To estimate the costs of anticipated inflation, I
have simulated its effects on the
economy
using a medium-scale structural econometric

u.s.

The simulation shows that these two influences
more than offset the Fisher effect; nominal interest rates in the economy rise by only seven
tenths of a percentage point for each one percentage point increase in the steady-state rate
of inflation. This estimate is similar in magnitude
to other estimates that have been obtained using
alternative approaches.
Consequently, this simulation suggests that a rise
in expected inflation reduces real after-tax interest rates. This means that when expected inflation rises, sectors that tend to respond to real
interest rates will gain relative to those that
respond to nominal interest rates.
The accompanying table shows the changes in
resource allocation caused by a five-percentage
point increase in anticipated inflation. Some of
the largest impacts are on household investment
in consumer durables and residential structures.
Because of liquidity constraints, households respond more strongly to changes in nominal interest rates than to changes in real interest rates.
Thus, although real interest rates fall in the simulation, higher nominal interest rates reduce
household investment in durables by 10 percent and residential investment by 7.5 percent.

Because of the increased costs of investing in
consumer durables and housing, households
increase their expenditures on nondurables
and services by 1.5 percent.

Estimated Effects of 5 Percent Anticipated Inflation
Percent
Change
in Sector
Consumption
Durables
Nondurables and Services
Residential Investment
Nonresidential Investment
Inventory Investment
Government Spending
Net Exports

Percent
Contribution
to Real GNP

-10.0
1.5

-1.0
1.0

-7.5

-0.4

-1.0

-0.1

0.0

0.0

0.0

0.0

30.5

0.5
Sum 0.0

Business investment
As previously discussed, the business sector of
the economy is not liquidity constrained the way
households are. Business investment therefore
responds primarily to changes in real after-tax
interest rates, rather than to changes in nominal
interest rates. The decl ine in real after-tax interest
rates associated with the five-percentage point
increase in anticipated inflation tends to stimulate business investment in plant and equipment.
At the same time, however, the higher inflation
also increases the effective rate of taxation on
business investment, an effect which tends to
work in the opposite direction. As it turns out,
the latter effect dominates slightly, and nonresidential fixed investment drops by one percent.
Similar tax and real interest rate effects may be
present for inventory investment. But like other
studies that have investigated this issue, this
study did not find a statistically significant relationship between inventory investment and the
after-tax cost of capital. Therefore, the impact
of inflation on inventory investment is estimated
to be nil.

inflation, net investment in foreign assets rises.
This occurs because the decline in U.S. real interest rates makes investing abroad more attractive.
These larger capital outflows act to depreciate
the dollar and raise net exports. Net exports
are estimated to rise by 0.5 percent of GNP.
The increase in net investment in foreign assets
is not enough to offsetthe decline in investment
in domestic assets, however. As a result, the overall rate of saving and investment in the economy
falls. As noted above, because consumption becomes relatively less expensive than investment
in durables and housing, household spending on
nondurables and services rises by 1.5 percent. As
a result, national saving (including the saving
implied by households' investment in consumer
durables) falls by an equal amount. This reduction in saving amounts to one percent of GNP.
The decline in saving is matched by an equal
reduction in national investment. Total domestic
investment falls by 1.5 percent of GNP, while net
foreign investment rises by 0.5 percent of GNP,
causing a net decline in national investment
equal to one percent of GNP.

Significant distortions
Some of the most widely recognized costs of
inflation arise when it is not anticipated. It is
less well recognized, however, that even when
inflation is anticipated, it significantly distorts
economic decisions. Increases in anticipated inflation in the
economy raise nominal interest
rates and reduce real rates. This raises net foreign
investment at the expense of domestic investment, and favors business investment over household investment, even though the effective tax
rate on business investment rises. Increases in
anticipated inflation also tend to reduce the
economy's overall rate of saving and investment.
Heightened liquidity constraints created by loan
market imperfections primarily are responsible
for this shift in resource use, although an increase
in the effective tax rate on business investment
also plays a role. As a result, the allocation of resources is less efficient than if prices were stable.

u.s.

National saving and investment
Although investment spending by households
and businesses declines as a result of anticipated

Adrian W. Throop
Research Officer

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.

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