Inflation: Causes, Costs, and Current Status
Marc Labonte
Specialist in Macroeconomic Policy
July 26, 2011
Congressional Research Service
7-5700
www.crs.gov
RL30344
CRS Report for Congress
P
repared for Members and Committees of Congress
Inflation: Causes, Costs, and Current Status
Summary
Since the end of World War II, the United States has experienced almost continuous inflation—
the general rise in the price of goods and services. It would be difficult to find a similar period in
American history before that war. Indeed, prior to World War II, the United States often
experienced long periods of deflation. It is worth noting that the Consumer Price Index (CPI) in
1941 was virtually at the same level as in 1807.
During the last two economic expansions, March 1991-March 2001 and November 2001-
December 2007, the inflation rate remained low by the standards of previous decades, and has
remained low since this recession began. This is true regardless of which index is used to
calculate the rate at which the price of goods and services rose. A low inflation rate is especially
significant since the U.S. economy was fully employed, if not over fully employed, according to
many estimates for the last three years of the 1991-2001 expansion and during 2006-2007. Yet,
contrary to expectations, the inflation rate accelerated only modestly. Keeping an economy
moving along a full employment path without igniting a burst of inflation is a difficult policy
task.
Because labor costs make up nearly two-thirds of total production costs, the rate at which they
rise is often regarded as an indication of future inflation at the retail level. They tended to rise in
the latter stage of the 1991-2001 expansion and to moderate during the subsequent contraction,
recovery, and expansion that ended in December 2007.
Rather than measure inflation by using the rate at which prices overall are rising, some
economists prefer a measure that reflects primarily the systematic factors that raise prices. This
yields the “underlying” or “core” rate of inflation. Price increases over this period have been
especially sharp in food and energy, which are not included in the core rate.
Why should the United States be concerned about inflation? This study reports the distilled
knowledge of economists on the real cost to an economy from inflation. These are remarkably
more varied than the outlays for “shoe leather,” long reported to be the major cost of inflation
(“shoe leather” being a shorthand term for the resources that have to be expended on less efficient
methods of exchanges).
The costs of inflation are related to its rate, the uncertainty it engenders, whether it is anticipated,
and the degree to which contracts and the tax system are indexed. A major cost is related to the
inefficient utilization of resources because economic agents mistake changes in nominal variables
for changes in real variables and act accordingly (the so-called signal problem). Inflation in the
United States during the post-World War II era may not have been high enough for this cost to be
significant.
Congressional Research Service
Inflation: Causes, Costs, and Current Status
Contents
Introduction ................................................................................................................................ 1
Inflation Defined......................................................................................................................... 1
Causes of Inflation ...................................................................................................................... 1
The Relationship Between Inflation and Unemployment ....................................................... 3
Inflation and Expectations..................................................................................................... 3
The Economic Costs of Inflation ................................................................................................. 4
Inflation Costs in a Fully Indexed Economy ................................................................................ 4
Inflation Costs in a Partially Indexed Economy ........................................................................... 5
Inflation Anticipated ............................................................................................................. 5
Inflation Unanticipated.......................................................................................................... 7
Inflation and Uncertainty............................................................................................................. 8
Can A Little Inflation “Grease the Wheels” of the Economy? ...................................................... 8
Economic Costs of Inflation: Summary ....................................................................................... 9
The Measurement of Inflation ................................................................................................... 10
Changes in the Prices of Goods and Services....................................................................... 10
The Underlying or Core Rate of Inflation .................................................................................. 10
Changes in Labor Costs....................................................................................................... 12
Conclusion................................................................................................................................ 12
Contacts
Author Contact Information ...................................................................................................... 13
Acknowledgments .................................................................................................................... 13
Congressional Research Service
Inflation: Causes, Costs, and Current Status
Introduction
Inflation—the general rise in the prices of goods and services—is one of the differentiating
characteristics of the U.S. economy in the post-World War II era. Except for 1949, 1955, and
2009, the prices of goods and services have, on average, risen each year since 1945. The
cumulative effect of this inflation is staggering: the price level has risen more than 1,000% since
the end of World War II.1 Inflation rose in the 1960s, peaked in the 1970s and early 1980s, and
has been generally low but positive since then.
This was not true in the pre-World War II period. On the eve of that war, 1941, the U.S. price
level was virtually the same as in 1807. During the periods from 1846 to 1861 and 1884 to 1909,
the United States experienced a near constant price level. And in the 15 years from 1865 through
1879, the price level either remained constant or declined. The principal periods of inflation
between 1800 and 1941 were associated with wars and the discoveries of gold and silver both
here and abroad (and with increased efficiencies in extracting both metals).
Inflation Defined
Inflation can be defined as a sustained or continuous rise in the general price level or,
alternatively, as a sustained or continuous fall in the value of money. Several things should be
noted about this definition. First, inflation refers to the movement in the general level of prices. It
does not refer to changes in one price relative to other prices. These changes are common even
when the overall level of prices is stable.2 Second, the prices are those of goods and services, not
assets. Third, the rise in the price level must be somewhat substantial and continue over a period
longer than a day, week, or month.3
Causes of Inflation
There has been practically no period in American history in which a significant change in the
price level has occurred that was not simultaneously accompanied by a corresponding change in
the supply of money.4 This has led to a widely held view that “inflation is always and everywhere
1 In this and the following paragraph, all changes in the price level are as measured by the Consumer Price Index.
2 Especially troublesome for the definition of inflation is how to define a rise in the price of an important commodity
such as oil. Since it enters as an important input into the production process as well as being a final product, it may
cause many other individual prices to rise. Is this a rise in relative prices or is it more appropriately defined as inflation?
Economists differ on how to describe this phenomenon. Some blame OPEC for the inflation of the 1970s and early
1980s. Others treat this as a rise in relative prices and attribute the inflation of the period to misplaced policies of the
Federal Reserve.
3 The words “somewhat substantial” cannot be defined precisely. All of the major price indexes have a number of
shortcomings, such as only imperfectly correcting for changes in the quality of the goods and services contained in the
index. For that reason, relatively low rates for inflation (e.g., plus or minus 2% or less) are often taken to be equivalent
to price level stability.
4 Perhaps the only exception to this statement is the inflation during the Korean War of 1950-1953.
Congressional Research Service
1
Inflation: Causes, Costs, and Current Status
a monetary phenomenon resulting from and accompanied by a rise in the quantity of money
relative to output.”5
Although this view is generally accepted, it is, in fact, consistent with two quite different views as
to the cause of inflation.
In one view a more rapid rate of money growth plays an active role in inflation and results either
from mistaken policies of the Federal Reserve or because the Federal Reserve subordinates itself
to the fiscal requirements of the federal government and finances budget deficits through money
creation. Examples of Federal Reserve policies that are likely to produce inflation are those that
fix rates of interest too low or that support unrealistic foreign exchange values of the dollar.
According to this view, the control of inflation rests with the Federal Reserve (Fed) and depends
upon its willingness to limit the growth in the money supply.6 Because of this relationship, some
economists are concerned about the rapid growth in the portion of the money supply controlled
by the Fed (called the monetary base) from 2008 to 2011, although to date the rise in the
monetary base has not been accompanied by a proportionate increase in the broader money
supply, mainly because of the large slack in the economy at the time.7
An alternative view comes in several versions. They have in common a belief that the major
upward pressure on prices comes from activities which would produce a fall in real output. A
favorite candidate is the attempt by organized labor to obtain increases in real wages. Other
activities include the monopolistic pricing behavior of OPEC, major crop failures or changes in
the terms of international trade produced by a decline in the foreign exchange value of the dollar.
The decline in real output that these activities produce will, in general, lead to rises in
unemployment. To prevent unemployment from increasing, in one version of this alternative, the
Federal Reserve is seen to pump up demand by easing the growth of money and credit. In the
process it ratifies the rise in the price level. Thus, in this version, while a growth in the money
supply is necessary to ratify the upward movement in the price level, it is not the cause of the rise
in prices.
It is interesting to speculate what would happen if the Federal Reserve refused to expand demand
in the face of the rise in unemployment. Presumably, after a protracted period, the additional
unemployment would lead to a fall in wages, costs, and other prices. Over the longer run, output
would return to its previous level or growth path, the price level would fall back to its previous
level and only relative prices and wages would be different. Thus, while the Federal Reserve has
the power to curb inflation, it is unlikely to exercise this power in the face of a large run up in
unemployment.
In another extreme variant, what the Federal Reserve does is really irrelevant. Should it refuse to
expand what is conventionally called money to pump up demand in the presence of these
developments that reduce output, money substitutes under the guise of credit will emerge that will
allow demand to grow and the price increases to be ratified. This variation, interestingly,
precludes excessive money growth from causing inflation, for it also holds that the Federal
5 Milton Friedman, What Price Guideposts in Guidelines: Formal Controls of the Marketplace, Aliber, Robert and
George Schultz, ed. (University of Chicago Press, 1966), p. 18.
6 For more information, see CRS Report RL30354, Monetary Policy and the Federal Reserve: Current Policy and
Conditions, by Marc Labonte and Joseph R. McCormack.
7 For more information, see CRS Report R41540, Quantitative Easing and the Growth in the Federal Reserve’s
Balance Sheet, by Marc Labonte.
Congressional Research Service
2
Inflation: Causes, Costs, and Current Status
Reserve cannot force too much money on the economy. Inflation, then, cannot be a case in which
too much money is chasing too few goods.8
The first two explanations for inflation find many adherents among American economists,
whereas the third is more common among some British economists.
The Relationship Between Inflation and Unemployment
In most years, inflation tends to rise when unemployment falls, and vice versa. Economic theory
explains this relationship in terms of a full employment rate of unemployment, also called the
natural rate of unemployment or the non-accelerating inflation rate of unemployment (NAIRU).9
Whenever the actual unemployment rate is above the full employment rate, total spending in the
economy will fall, and the resultant slack will cause the inflation rate to fall (since there is less
demand for goods and services). As the inflation rate falls, the expected rate of inflation should
also fall if economic agents believe the government is sincere in its efforts to end inflation (i.e.,
that the government will not reverse its policy in the face of rising unemployment). As inflation
expectations fall so will wage demands, and falling wage demands will bring about a lower
unemployment rate (since employers will have more demand for labor when labor costs fall).
Ultimately, the economy will move back to full employment at a zero inflation rate or a stable
price level. Thus, the important steps in the sequence are (1) a convincing government policy to
reduce the inflation rate to zero; (2) toleration of an above normal rate of unemployment; and (3)
the adjustment of inflation expectations and wage demands to the lower rate of inflation. In
practice, policymakers have shown a preference for stimulating the economy before inflation hits
zero, so that unemployment returns to the full employment rate faster. As a result, most recessions
have featured a falling but still positive inflation rate.
Inflation and Expectations
Economists believe that expectations of future inflation play an important role in the relationship
between inflation and unemployment. To illustrate why, consider the example of tightening
monetary policy (raising short-term interest rates) to reduce the inflation rate. Higher interest
rates reduce spending on interest-sensitive goods, such as business investment spending,
consumer durables, and housing. As spending on these goods declines, so will employment in the
sectors producing these goods. If inflation expectations are low, the overall decline in spending
and employment will put downward pressure on prices, as discussed in the previous section. But
if inflation expectations are high, prices will respond less quickly to the same decline in spending
and employment. As a result, spending and employment would have to fall further and longer to
produce the same decline in prices. Whether inflation expectations are high or low will depend
importantly on the perceived credibility of the Fed’s commitment to maintaining low inflation. If
businesses and workers do not believe that the Fed will stick with a policy of tighter monetary
policy when faced with higher unemployment, they may not be willing to lower their price
demands and wage demands, respectively.
8 This view is commonly held by economists associated with the late Nicholas Kaldor and systematically explained by
him in “Monetarism and U.K. Monetary Policy,” Cambridge Journal of Economics, vol. 4 (1980), pp. 293-318.
9 For more information, see CRS Report RL30391, Inflation and Unemployment: What is the Connection?, by Brian
W. Cashell.
Congressional Research Service
3
Inflation: Causes, Costs, and Current Status
The Economic Costs of Inflation
Economists often discuss jointly the costs to an economy from unemployment and inflation
because, for much of the period since the late 1950s, it was generally believed that a long-run
tradeoff existed between the two.10 While the cost of unemployment was well articulated, the cost
of inflation was relegated to “shoe leather.”11
The high U.S. inflation rate of the late 1960s, 1970s, and early 1980s caused economists to
rethink the costs of inflation to an economy. What follows is a distillation of those efforts.
Describing the costs to an economy from inflation can be confusing for several reasons. First and
foremost there is the confusion over the cost to the economy versus the cost to specific
individuals. Costs to individuals may not impose a burden on the economy because they are in the
nature of a redistribution of either income and/or wealth. What is lost by some is gained by
others. Nevertheless, some of these redistributions can have real effects.
Second, some of the costs of inflation are permanent in the sense that so long as the inflation
continues the costs will be incurred. Others are only transitory and arise as the economy moves
from one inflation rate to another or because the rate of inflation itself is variable.
Third, some costs are incurred only because the inflation is unanticipated while other costs arise
even when the inflation is fully anticipated. Finally, some costs occur only because of the absence
for one reason or another of appropriate safeguards: for example, the absence of indexed
contracts.
Inflation Costs in a Fully Indexed Economy
As an introduction to understanding the costs imposed on an economy by inflation, consider first
an economy that is completely indexed for inflation. Thus every conceivable contract is adjusted
for changes in the price level including those for debt (bonds and mortgages) and wages and
salaries; where taxes are imposed only on real returns to assets, where tax brackets, fines and all
payments imposed by law are indexed, where the exchange rate is free to vary and there are no
legal restrictions imposed on interest rates, etc.
In this economy, the distinction between anticipated and unanticipated inflation is unimportant
except if the inflation rate is high and the indexed adjustments are not continuous. Then real costs
can occur. However, for analytical purposes, assume that all individuals perfectly anticipated the
inflation and that the indexed adjustments are continuous.
10 A comprehensive discussion of the costs of inflation can be found in Fischer, Stanley, and Franco Modigliani,
“Towards an Understanding of the Real Effects and Costs of Inflation,” Weltwirtschaftliches Archiv, vol. 114, no. 4
(1978), pp. 736-787.
11 Before financial institutions could pay explicit interest on deposits that function as money, economists believed that
individuals and businesses would shift their wealth into savings-type deposits on which interest was paid. Because of
this, they would have to make more frequent trips to banks to obtain money. This involved primarily a cost of shoe
leather, as shoes wore out more frequently because of the increased number of trips. Hence the often expressed view
that the primary cost of inflation to an economy was “shoe leather.” More generally, it refers to the resources devoted
to avoiding anticipated inflation.
Congressional Research Service
4
Inflation: Causes, Costs, and Current Status
In this economy, inflation can impose only two real costs: the less efficient arrangement of
transactions that result from holding smaller money balances and the necessity to change posted
prices more frequently (the so-called menu costs).
The first of these, entailing the rearrangement of transactions due to the higher costs of holding
money, is the one cost uniformly identified in the text books as “the cost of inflation.” It is worth
considering what is involved.
Both individuals and businesses hold money balances because it allows each to arrange
transactions in an optimum or least cost way (e.g., for business this involves paying employees,
holding inventories, billing customers, maintaining working balances, etc.) and to provide
security against an uncertain future. Holding wealth or assets in a money form, however, is not
costless. A measure of the so-called opportunity cost is the expected rate of inflation, a cost that
rises because wealth can be held in alternative forms whose price or value rises with inflation.
When inflation occurs or when the rate of inflation rises, holding money becomes more costly.
Individuals and businesses then attempt to get by with less money (for businesses this may mean
billing customers more frequently, paying employees more frequently, etc.). This means that least
cost transactions patterns are no longer least cost. The new patterns are less efficient—they use
more time or more resources to effect a given transaction. In addition, holding smaller real money
balances also reduces the security money provides against an uncertain future.
The magnitude of this cost has been reduced in the United States in recent years because financial
institutions can now pay interest on a variety of deposits that function as money. Thus, the
primary cost of inflation on money holding applies to currency on which no interest is paid. To
the extent, however, that financial institutions are slow to raise interest rates in tandem with
inflation, deposit holders will economize on holding deposits and arrange transactions less
efficiently, thereby imposing a short-run cost on the economy.
The other cost imposed by inflation in a fully indexed economy is the so-called menu cost, which
involves the extra time and resources that are used in adjusting prices more frequently in an
environment where prices are rising. These additional costs are incurred mainly with goods and
services that are sold in nonauction markets. It does not apply to auction markets where prices
change more or less continuously in response to shifts in supply and demand.
Inflation Costs in a Partially Indexed Economy
Inflation Anticipated
Very few economies are fully indexed, even those in which inflation is severe. In the United
States, indexation is incomplete. As such, inflation can impose costs even if it is fully anticipated.
A case in point involves the arrangements for levying taxes. Taxes are levied in several instances
on nominal as opposed to real income. As a result, the interaction of inflation and taxation can
impose real effects on an economy by altering the incentives to work, save, and invest. Several
examples should suffice to explain what is involved.
First, consider an individual who, in a non-inflationary period, earns a real rate of interest of 5%
and who pays taxes of 30% on this income. The aftertax real rate of interest is 3.5%, that is,
Congressional Research Service
5
Inflation: Causes, Costs, and Current Status
[5% –(30% × 5%)]. Now, assume that a 10% rate of inflation is expected over the one-year term
of the loan. As a result, the market rate of interest rises to 15% (composed of a real rate of 5% and
an expected inflation rate of 10%). At a tax rate of 30%, the aftertax rate of return falls to 0.5%.12
To the extent that saving is responsive to the real aftertax rate of return, taxing nominal yields, as
is done in the United States, distorts the incentive for individuals to save.13 (The existing
empirical evidence for the United States suggests that private sector saving is quite insensitive to
the aftertax rate of return.)
Second, consider what happens to the real aftertax rate of return on business capital during an
inflation. For tax purposes, the depreciation of business plant and equipment is based on actual or
historic costs. During an inflation, charging depreciation based on historic cost raises the nominal
profits of businesses and the basis on which corporate profits taxes are levied. As a result, the
aftertax real rate of return falls and this discourages businesses from adding to their stock of
plant, equipment, and structures—the bases for future economic growth.14 15
Third, to the extent that income tax brackets are not indexed or not indexed completely, inflation
in a progressive income tax system can reduce the real aftertax income for wage and salary
earners over time, distorting the incentives to work.
During the 1980s, the U.S. tax code was rewritten to adjust the tax brackets for inflation as well
as to reduce the level and progressivity of the federal income tax. As a result, inflation has a much
reduced interaction with federal taxes in reducing aftertax real income.
Several private sector practices also interact with inflation to produce real economic effects. The
first is the continuation of level payment nominal mortgages for financing housing. This practice
front loads the real cost of a mortgage during an inflation and, as a result, it discourages the
purchase of homes, especially by younger first-time buyers.
Second, business firms continue to record all data in terms of the dollar even though the real
purchasing power of this important unit of measure varies considerably over time. This practice
has the potential for distorting the real profitability of business over time as well as the valuation
of other relevant magnitudes. Since these nominal magnitudes are frequently used as the basis for
borrowing and lending decisions, they have the potential for seriously distorting resource
allocations.16
12 The after-tax real rate is equal to: 15% - 4.5% (which is 30% of 15%) = after-tax nominal yield of 10.5% - 10.0%
inflation = 0.5% real after-tax yield.
13 The possibility arises that the interaction of inflation and the taxation of nominal rates of return will produce negative
aftertax real rates of return.
14 The taxation of nominal profits may also encourage business to opt for shorter-lived capital during an inflation. In
addition, since interest expenses are deductible for tax purposes, inflation encourages businesses to finance expansion
by the use of debt as opposed to equity. This can impart an element of instability to the financial structure of the
economy.
15 Inflation can also influence some public decision-making because it leads to a misrepresentation of the reported
statistics on which these decisions are made. Specifically, the Federal budget deficit tends to be overstated because the
inflation premium in interest rates that represents the repayment of principal, is reported as interest expense in both the
federal budget accounts and the GNP accounts. To the extent that public concern centers on the current operating
outlays of the federal government, true interest outlays are considerably less than currently reported in the budget and,
thus, the current operating deficit is much smaller than reported in the federal budget document.
16 These distortions could be minimized if the dollar was defined as a real unit of account (e.g., defined in terms of a
standard basket of commodities). Several proposals for doing so have been put forth. See Warren L. Coats, Jr., In
(continued...)
Congressional Research Service
6
Inflation: Causes, Costs, and Current Status
Inflation Unanticipated
In this section, the real effects of inflation are analyzed in an environment where it is
unanticipated and where the economy relies on nominal or unindexed contracts. In this situation,
an important effect of inflation is to redistribute both income and wealth. It would be a mistake,
however, to conclude that because gainers and losers cancel, there can be no real effects from
inflation.
To see one such real effect, consider what happens to the interest bearing public debt. Inflation
reduces the real value of the public debt and with it the real value of the wealth of the private
sector, the ultimate owners of most of that debt. Thus, inflation redistributes wealth from the
private to the public sector. But who constitutes the public sector? These are the taxpayers who
also happen to be the members of the private sector, some of whom own the debt.
Thus, redistribution reduces the real value of the taxes needed to service this debt, and the
reduction is most beneficial for the younger workers in the current population and for future
generations. As a result of the fall in real tax burden, their real disposable income rises, both
today and in the future. They are thus able to save more while older workers and retirees will, no
doubt, have to reduce their consumption, for while they are faced with a large wealth loss, they
gain very little from the reduced tax burden. Thus, the redistribution of wealth between the
private and the public sectors is really a redistribution between generations that could have an
effect on the rate of capital formation.
Perhaps the most serious effect of unanticipated inflation in a market economy is its potential to
make the price system malfunction and misallocate resources. Those who live in market
economies are apt to take its functioning for granted. They may fail to appreciate or understand
the vital role that prices perform in such a system. As standard textbooks in economics teach, the
price system determines what is produced, how it is produced, and to whom the output is
distributed.
For the price system to perform these functions efficiently, producers must be able to discern a
change in real or relative prices from a change in nominal prices which essentially leaves all
relative prices unchanged. Only with the former will it be profitable to alter production. A similar
phenomenon holds for workers. A rise in money wages may bring forth a greater quantity of labor
time if workers are convinced that this is a rise in real wages, that is, money wages relative to
prices.17
It is easier for producers and workers to discern these changes in real prices and wages if the price
level is stable or if the inflation rate is constant. It is more difficult when the rate of inflation is
rising and/or more variable. Under these circumstances market economies are apt to have “signal”
problems. That is, producers and workers mistake changes in nominal prices and wages for
changes in corresponding real magnitudes and act accordingly. The resulting changes in output
(...continued)
Search of Monetary Anchor: A “New” Monetary Standard, IMF Working Paper, 1989.
17 The key word in this explanation is “may,” for a rise in real wages has both a substitution and an income effect. The
substitution effect will cause workers to substitute work for leisure while the rise in real income will make leisure a
more attractive option to working. Whether the quantity of labor time increases or decreases as the real wage rises will
depend on which effect is stronger.
Congressional Research Service
7
Inflation: Causes, Costs, and Current Status
and labor time are inefficient and would not have occurred but for the mistakes in perception.
Some economists, including Fed Chairman Ben Bernanke, have argued that low and stable
inflation is conducive to higher long-term economic growth.18 A “signal extraction” problem may
not have arisen in the United States, however, since rates of inflation have been relatively low
and stable.
Inflation and Uncertainty
Empirical studies completed in the 1970s support the view that inflation is associated with greater
uncertainty about future prices and that the degree of uncertainty rises with the rate of inflation.19
Rising uncertainty about future prices is believed to produce several possible “real” effects. First,
individuals appear to shift from buying assets denominated in nominal terms (e.g., bonds) to so-
called real assets such as residential structures, land, precious metals, art work, etc. Because some
of these assets are in fairly fixed supply, the resulting capital gain produced by the shift could
conceivably raise private sector wealth by a sufficient amount to cause a fall in the saving rate.
Second, to compensate for the perceived greater uncertainty, lenders appear to require a greater
real reward for supplying funds for investment. Third, contracts tend to be shortened.
The first two developments lead to rising real interest rates, which tend to reduce the rate of
investment and capital formation. The third development leads businessmen to prefer shorter
lived assets.
Can A Little Inflation “Grease the Wheels” of
the Economy?
A few prominent economists have broken with the mainstream view that inflation should be kept
to a minimum. They have argued that moderate rates of inflation, in the 3%-5% range rather than
the 1%-3% range, might be useful for smoother economic adjustment.20 In a downturn, economic
output falls because of “price stickiness”—prices and wages cannot adjust quickly enough to
maintain full employment, so total spending falls below the productive capacity of the economy.
These economists argue that with a higher average rate of inflation, adjustment would happen
more quickly because real wage or price cuts would be possible while avoiding nominal wage
cuts. For example, a worker might resist a 2% nominal cut in his wages when inflation is zero,
but accept a 3% nominal wage increase when inflation is 5%. In both cases, real wages would
have adjusted downward by 2%, but the latter example would have possibly occurred more
quickly. Inherent in this view is that individuals suffer from some “money illusion” at moderate
rates of inflation (i.e., a 2% real wage cut is accepted because the 3% nominal increase is not seen
18 Ben Bernanke Testimony Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate
November 15, 2005.
19 There are numerous studies that provide support for this view. Some are cited in the references in the Fischer and
Modigliani study on which this section is based.
20 See, for example, George A. Akerlof, William T. Dickens, George L. Perry, The Macroeconomics of Low Inflation,
Brookings Papers on Economic Activity, Vol. 1996, No. 1 (1996), pp. 1-76. Laurence Ball, Testimony Before the
House Committee on Financial Services, March 25, 2010.
Congressional Research Service
8
Inflation: Causes, Costs, and Current Status
as a cut.) The existence of “money illusion” is inconsistent with anticipated inflation, and is only
possible if inflation is insignificant; there is significant evidence that individuals in high inflation
economies are highly sensitive to the inflation rate.21
Another argument made for targeting a higher (but still moderate) inflation rate is that deflation
(falling prices) is a more serious problem than inflation, with Japan as an example of a country
stuck in a long period of deflation and sluggish economic growth. A higher average inflation rate
makes it less likely that a country would slide into deflation during a downturn. The reason that it
could be hard to escape deflation is related to the “zero bound” on monetary policy.22 The Federal
Reserve can only reduce short-term interest rates to zero when it is stimulating the economy, but
sometimes, as was the case in 2008, further stimulus is needed to end a recession. With a higher
average rate of inflation, average interest rates would also be expected to be higher. Higher
average interest rates would be further from the zero bound on average, so that the Federal
Reserve could undertake more stimulus before hitting the zero bound. This argument neglects the
fact that the Fed can undertake (and has recently undertaken23) unconventional monetary policy
actions and expansionary fiscal policy to further stimulate the economy at the zero bound.
Economic Costs of Inflation: Summary
What is the cost of inflation? It is customary in textbooks to answer this question in terms of a
situation where the rate of inflation is anticipated by all market participants who can either
continuously re-contract or in which everyone is protected from inflation through indexation. In
this world the cost to an economy from inflation is the increased resource cost from conducting
transactions with reduced holdings of money—popularly termed “shoe leather” costs. If the
inflation is serious, this cost is by no means trivial.24
However, inflations are seldom perfectly anticipated. In this situation, perhaps the most serious
real effect comes from the ability of rising prices to jam the price signals that are so important to
the smooth and efficient functioning of a market economy. Evidence suggests that this may not
have been a problem for the United States in the post-World War II era.
In general, the cost of inflation to an economy will be larger the higher the rate of inflation, the
more variable the rate, the less it is anticipated, the greater is the uncertainty it causes, and the
less indexed is the economy.
21 While proponents of a higher but still moderate inflation target would not deny that there would be higher “shoe
leather” costs associated with such a proposal, they would argue that the higher costs would not be great enough to
outweigh the benefits.
22 See, for example, Olivier Blanchard et al., “Rethinking Macroeconomic Policy,” International Monetary Fund, Staff
Position Note 10/3, February 2010.
23 For more information on recent unconventional monetary actions, see CRS Report RL34427, Financial Turmoil:
Federal Reserve Policy Responses, by Marc Labonte.
24 It should be noted that this is not a one-time cost. The costs will be incurred as long as the inflation continues.
Congressional Research Service
9
Inflation: Causes, Costs, and Current Status
The Measurement of Inflation
Changes in the Prices of Goods and Services
There is no single measurement of inflation. The rise in the general level of prices, the essence of
inflation, is measured by using a price index that aggregates the price of different goods and
services. Ideally, the price index used should be broad based and one in which the individual
prices are weighted to indicate their importance to the economy. Many different price indexes are
available in the United States that measure different types of inflation rates.
For purposes of this report, two separate price indexes are used. The first is very broad based and
derived from the measurement of the nation’s gross domestic product (GDP), covering price
changes of consumption, investment, government, and traded goods. The other is the Consumer
Price Index (CPI), which prices a “market basket” of goods and services purchased by an urban
family, a market basket whose individual items are weighted by how much the urban family spent
on them in a base year period—currently 1982-1984. Inflation rates according to the two
measures are usually similar. Inflation, according to the CPI, was very low (usually below 2%) in
the 1950s and early 1960s, began rising in the late 1960s, was relatively high in the 1970s and
early 1980s (rising above 10% in 1974 and 1979-1981), began falling in the mid-1980s, and
generally remained in the 2%-3% range in the 1990s and 2000s. 25 Inflation tends to rise over the
course of an economic expansion and decline during an economic recession, for reasons
discussed above (see “The Relationship Between Inflation and Unemployment”).
Current CPI data can be accessed at http://www.bls.gov/news.release/pdf/cpi.pdf.
Current data for the GDP price deflator can be accessed at http://www.bea.gov/newsreleases/
national/gdp/gdpnewsrelease.htm.
The Underlying or Core Rate of Inflation
When comparing purchasing power over two time periods, the overall (referred to as “headline”)
inflation rate is the relevant measure. Comparisons over time of wages, wealth, rates of return,
government transfers such as Social Security payments, and so on should all use a headline
measure of inflation, because all of these concepts depend on a broad measure of inflation.
Although the headline rate of inflation can provide much useful information to policymakers on
the state of the economy, it can also be misleading since it responds to both systematic and
random forces. The latter can best be understood by reference to the food component of the CPI.
An unusual cold spell in Florida in January that damages a substantial part of the fresh produce
crop can send food prices and the CPI soaring. A similar effect can be produced by an unusually
wet summer in the Midwest. Alternatively, an unusually good combination of rain and sunshine
can produce a bountiful harvest and lower prices. Energy prices are also susceptible to such
random effects associated with events such as turmoil in major oil producing nations.
25 Given that the CPI imperfectly measures the “true” rate of inflation, a stable price level or a “true” zero rate of
inflation is thought to prevail when the inflation rate as measured by the CPI falls within a range of from 0.5% to
2.0%—this being the possible range of error in the current CPI.
Congressional Research Service
10
Inflation: Causes, Costs, and Current Status
To minimize the confusing signals that could arise from the use of the actual rate of inflation,
some economists prefer to use a price index that reflects basically only systematic forces to
measure inflation. For some economists, this can be achieved by using the CPI less its food and
energy components. (It should be noted that food and energy represent about 25% of the current
CPI.) Others want to use a moving average either of the CPI itself or of the current CPI less its
food and energy components. The use of a moving average is based on the belief that if there are
random factors that influence the actual inflation rate, they have an average value of zero. Hence,
the use of a moving average should minimize their influence. Others prefer a more complicated
measure that trims off whatever prices have changed most in that period.26
Policymakers, particularly at the Federal Reserve, often refer to core inflation in their policy
decisions. Some policymakers prefer to use core inflation to predict future overall inflation
because food and energy price volatility makes it difficult to discern trends from the overall
inflation rate. A drawback of an over-reliance on core inflation, however, is that an extended
period of rapidly rising food or energy prices could cause all other prices to accelerate. A focus on
core may cause policymakers to fail to react to such a rise in inflation until it is too late. This
scenario may have occurred in the last decade. Since CPI less food and energy was higher than
headline CPI in each year of the decade except 2002 and 2009, a focus on core inflation may have
led policymakers to wait too long to tighten policy in the expansion. Furthermore, several studies
have failed to find core inflation to be a good forecaster of future inflation, casting doubt on the
very rationale for relying on it. 27
Current data for the CPI less food and energy can be accessed at http://www.bls.gov/news.release/
pdf/cpi.pdf.
26 Economists have tried to find the best measure of core inflation according to different criteria. See Timothy Cogley,
“A Simple Adaptive Measure of Core Inflation,” Journal of Money, Credit and Banking, vol. 34, no. 1, February 2002,
pp. 94-113; Danny Quah and Shaun P. Vahey, “Measuring Core Inflation,” The Economic Journal, vol. 105, no. 432,
September 1995, pp. 1130-1144; Michael Bryan and Stephen Cecchetti, “Measuring Core Inflation,” in N. Gregory
Mankiw, ed., Monetary Policy, (Chicago: University of Chicago Press, 1994), p. 195; Todd Clark, “Comparing
Measures of Core Inflation,” Federal Reserve Bank of Kansas City, Economic Review, 2002:2, p. 5.
27See Robert Rich and Charles Steindel, “A Review of Core Inflation and an Evaluation of Its Measures,” Federal
Reserve Bank of New York, staff report no. 236, December 2005. This study examines the forecasting power of
inflation less food and energy, as well as alternative definitions of core inflation that have been proposed by others, and
found that “no core measure does an outstanding job forecasting [headline] CPI inflation ... we find no strong evidence
to suggest that a selected core measure will be able to retain its usefulness as a tool to forecast inflation for any given
period....” Todd Clark, “Comparing Measures of Core Inflation,” Federal Reserve Bank of Kansas City, Economic
Review, 2002:2, p. 5. This study did not find a statistically significant relationship between core inflation and future
headline inflation, although the relationship becomes significant when limited to a more recent time period. Michael
Bryan and Stephen Cecchetti, “Measuring Core Inflation,” in N. Gregory Mankiw, ed., Monetary Policy (Chicago:
University of Chicago Press, 1994), p. 195; and Julie Smith, “Weighted Median Inflation: Is This Core Inflation?”
Journal of Money, Credit, and Banking, April 2004, vol. 36, no. 2, p. 253. Both of these studies compared the
forecasting ability of many measures of inflation, and concluded that headline inflation is a better predictor of future
headline inflation than core inflation and weighted median measure of inflation performed best. Frederic Mishkin,
“Headline versus Core Inflation in the Conduct of Monetary Policy,” speech at the Business Cycles, International
Transmission and Macroeconomic Policies Conference, Montreal, Canada, October 20, 2007. This study used the Fed’s
macro model of the U.S. economy to show that when the Fed reacts to changes in headline inflation instead of core
inflation, future inflation will be slightly less volatile, but unemployment will be significantly more volatile.
Congressional Research Service
11
Inflation: Causes, Costs, and Current Status
Changes in Labor Costs
Because labor costs comprise nearly two-thirds of the value of final output, some economists
believe that they are an important determinant of the rate of inflation. However, changes in the
rate of growth of labor costs must be read with care. Wage increases can be driven by
productivity increases, tight labor markets, inflation, or fears of inflation. One way to determine
the force or forces driving wage increases is to examine what happens to per-unit labor costs. To
this end, two major measures of labor cost are available, a comprehensive measure of wage and
benefit costs, the employment cost index, and per-unit labor costs in the nonfarm business sector.
The growth rate of both measures of labor cost generally showed a tendency to accelerate during
the expansions of the 1980s and 1990s as labor markets tightened. Subsequent recessions and
growing unemployment had a depressing effect on the rise in both measures. During the
expansion beginning in 2002, the rate of increase in both measures was fairly comparable to the
inflation rate (meaning real wage growth was low) even as the unemployment rate fell.
Current data for the employment cost index can be accessed at http://www.bls.gov/news.release/
pdf/eci.pdf.
Current data for per unit labor costs can be accessed at http://www.bls.gov/news.release/pdf/
prod2.pdf.
Conclusion
Inflation can impose a real cost on society in terms of the efficiency with which the exchange
mechanism works, by distorting the incentives to save, invest, and work, and by providing
incorrect signals that needlessly alter production and work effort. Because of this, policymakers
should be concerned with the ongoing rate of inflation and any tendency for it to accelerate. An
additional reason for concern arises because efforts to reduce the rate of inflation have often been
associated with economic downturns. It should not be forgotten that the double-digit inflation of
the early 1980s was reduced only through an economic downturn during which the
unemployment rate rose to its highest level since the Great Depression of the 1930s. It is argued
that the tendency for the inflation rate to accelerate in the late 1980s was a major reason why the
Federal Reserve tightened monetary policy, which was also an important factor causing the
recession of 1990-1991. Inflationary developments subsequent to that recession have been
encouraging. The inflation rate has shown either no or only a modest tendency to rise as
unemployment came down. Using various measures, the inflation rate since 1993 was low by
standards of the preceding decade. Nonetheless, inflation has risen modestly preceding the 2001
and 2009 recessions, illustrating that this is still an important measure to watch for evaluating the
state of the economy. Given the relationship between inflation and the money supply, some
economists are concerned that the rapid growth in the portion of the money supply controlled by
the Fed from 2008-2011 could cause rapid inflation. To date, those concerns have not been
realized, primarily because of the large slack in the economy.
Congressional Research Service
12
Inflation: Causes, Costs, and Current Status
Author Contact Information
Marc Labonte
Specialist in Macroeconomic Policy
mlabonte@crs.loc.gov, 7-0640
Acknowledgments
This report was originally written by Gail E. Makinen, formerly of the Congressional Research Service.
Congressional Research Service
13