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short essays and reports on the economic issues of the day
2006 ■ Number 5

The Long-Run Benefits of Sustained Low Inflation
Richard G. Anderson
olicymakers at the Federal Reserve wage preemptive wars
against inflation; that is, they tend to tighten monetary
policy during economic expansions before incoming data
confirm an increased rate of inflation. Today, many market analysts believe the Federal Open Market Committee is nearing the
end of its most recent preemptive strike. Hence, it seems worthwhile to review the benefits that flow from sustained low inflation.
A common theme among Fed officials is that price stability—
typically defined as an inflation rate that is sufficiently low, stable,
and predictable so as not to be a factor in decisionmaking—is a
prerequisite for attaining maximum sustainable economic growth.
In his closing remarks at the August 2005 Federal Reserve Bank
of Kansas City policy conference, Chairman Greenspan said, “I
presume maximum sustainable economic growth will continue
to be our goal, with price stability pursued as a necessary condition to promote that goal.” Incoming Fed Chairman Bernanke
(2005) has written: “[T]he low-inflation era of the past two decades
has seen not only significant improvements in economic growth
and productivity but also a marked reduction in economic volatility, both in the United States and abroad, a phenomenon that has
been dubbed ‘the Great Moderation’...[A]s I have argued elsewhere,
there is evidence for the view that improved control of inflation
has contributed in important measure to this welcome change in
the economy.”
Typically, policymakers’ desired long-run inflation rate is a
slow increase in a broad index of consumer prices, excluding
food and energy. In part, the non-zero rate reflects an assumed
measurement bias due to imperfect adjustment for quality change
and the introduction of new goods; in part, the rate also embeds
a cushion against the risk that an adverse shock might corner
policymakers against the zero lower bound on nominal interest
The costs of sustained inflation at such a low rate primarily
are of two types. First, “monetary costs” arise as inflation reduces
the real return on money, inducing firms and households to needlessly incur additional costs to more closely manage their monetary assets. Inflation also muddies price signals by increasing the
difficulty of distinguishing temporary changes in goods’ prices
from permanent changes. Higher inflation also tends to attract
real resources, including new college graduates, into professions
such as law and financial services that benefit by creating hedges
and shelters against inflation.


In empirical studies, however, the estimated costs of moderate
inflation (versus an inflation rate low enough to be equated to
price stability) are small, often less than three-hundredths of 1
percentage point of annual GDP growth; see the papers by Bruno
and Easterly (1996) and Barro (1996). But this opinion is not
universally held. Dotsey and Ireland (1996) present a model in
which the combined impact of several effects, each individually
small, is large. Second, and perhaps more significant, are distortions due to the nominal nature of the U.S. tax system. Studies in
Feldstein (1999) and by Bullard and Russell (2004) suggest that
the level of real output is lower by approximately one-half to 1
percent for each 1 percentage point that the inflation rate is above
that associated with price stability. Yet, cross-country empirical
studies suggest little, if any, effect on output when inflation is
less than 15 to 40 percent per year.
In short: Measures of the trade-off between sustained inflation
and long-run economic growth remain extremely uncertain, as
evidenced in the recent conference volume by the Bank of Japan
(2004). Yet, almost uniformly, central bankers argue that sustained
low inflation, at a rate no greater than that defined as price stability plus a small cushion to avoid the zero lower bound on nominal
interest rates, is a prerequisite to realizing an economy’s maximum
long-run economic growth. Fortunately, recent surveys of inflation expectations in the United States suggest that the public is
confident the Federal Reserve will sustain such an environment
of low, stable inflation. ■
A longer essay on this topic is available on the author’s web page at Essay_CostsOfInflation.pdf.
Bank of Japan. Conference proceedings: “Sustained Economic Growth and Central
Banking.” Monetary and Economic Studies (Special Edition), December 2004.
Barro, Robert. “Inflation and Growth.” Federal Reserve Bank of St. Louis Review,
May/June 1996, 78(3), pp. 153-69.
Bernanke, Ben S. “What Have We Learned Since October 1979?” Federal Reserve
Bank of St. Louis Review, March/April 2005, 87(2, Pt. 2), pp. 277-82.
Bruno, Michael and Easterly, William. “Inflation and Growth: In Search of a
Stable Relationship.” Federal Reserve Bank of St. Louis Review, May/June 1996,
78(3), pp. 139-46.
Bullard, James B. and Russell, Steven. “How Costly Is Sustained Low Inflation for
the U.S. Economy?” Federal Reserve Bank of St. Louis Review, May/June 2004,
86(3), pp. 35-67.
Dotsey, Michael and Ireland, Peter N. “The Welfare Cost of Inflation in General
Equilibrium.” Journal of Monetary Economics, 1996, 37(1), pp. 29-47.
Feldstein, Martin. The Costs and Benefits of Price Stability. Chicago: University
of Chicago Press, 1999.

Views expressed do not necessarily reflect official positions of the Federal Reserve System.