Devon Zuegel on inflation

One of the interesting (or disturbing, maybe) things about teaching university economics over the last decade or more in a country like New Zealand is that our students have never experienced high inflation. Never. For incoming first-year students next year, mostly born in 2003 or 2004, the inflation rate has only been above five percent (on an annual basis) in two quarters (see the data here) in their lifetimes - in the September quarter of 2008 (5.1 percent) and in the June quarter of 2011 (5.3 percent). The latest data (for the September quarter of 2021) had annual inflation at 4.9 percent. For much of the last two decades (and more) the inflation rate has been under two percent per year. Individual prices may change, but the general price level overall barely moves at all (and it is the change in the general price level that defines inflation).

So, when we teach first-year students about the costs of inflation, we are talking to an audience about something they have never really experienced and can't recognise in the world around them. It's almost like this:

They have no idea, and so menu costs, shoe leather costs, and other costs of inflation are difficult for students to connect with their own experience. We can't use examples from the New Zealand context to illustrate these costs, because New Zealand really hasn't faced those costs in appreciable terms for decades. And jumping straight to examples of periods of hyperinflation (like Weimar Germany, Zimbabwe in the 2000s, or Venezuela more recently), makes inflation seem even more other-worldly to students.

So, I found it interesting to read this perspective from Devon Zuegel on inflation from earlier this week, drawing in part on their experience in Argentina. There is lots of good bits to Zuegel's post, and I encourage you to read it, but I want to focus on two bits on the costs of inflation. First, here (emphasis is theirs):

In turn, systemic uncertainty reduces people's willingness to make long-term investments. (For example, high-inflation Argentina has almost no mortgage industry.) This drawback in investment isn't predicted by the model that my friend had in mind, because the model doesn't take into account the uncertainty that inflation causes or its psychological impacts.

Inflation makes people uncertain about the future value (and purchasing power) of money. It makes lenders less likely to lend money (because they can't be sure about the value of what they will get paid back). You might argue that lenders can build higher expectations about inflation rates into the nominal interest rate they charge to borrowers. This involves recognising the importance of the Fisher equation: real interest rate ≈ nominal interest rate - inflation rate. If the inflation rate is higher, lenders will need to charge a higher nominal interest rate in order to receive the same (target) real interest rate. However, high inflation is also inherently more unstable, and therefore less predictable, so it is difficult for lenders to determine what interest rate they should charge. If they are risk averse, they could err on the side of caution and charge a higher interest rate to protect themselves, but that will deter borrowers and reduce investment in the economy.

Second, Devon notes that inflation creates real harms for everyday people in the economy (emphasis is theirs):

Wage adjustments are not just slow but also uneven across the economy. For example:

• A waiter might do okay when their tips are a percentage of prices, because as long as the restaurant's owner updates prices consistently (which they're very motivated to do), the tip-based wages will adjust accordingly. Their base pay will not adjust so quickly though, because the restaurant owner is unlikely to updated wages as fast as menu prices.

• A retiree with a pension is in a really tough spot, because pensions are rarely (if ever?) indexed to inflation, so over time their income gets eroded to zero.

• Architects are in a tough spot too. They usually charge large lump fees, so if they give you a quote at the beginning of the year and then inflation hits, the real value of the quote they gave you went way down by the time you actually pay for their services.

As a general rule, inflation disproportionately harms people who can't easily adjust their income upwards. Fixed contracts and fixed incomes are especially vulnerable. Wages also don't automatically adjust—you generally need to advocate for yourself to get a raise—so if you lack negotiating skills in a high-inflation economy, you're at a significant disadvantage.

Anyone who can't adjust their income easily is going to be harmed by high inflation. As Zuegel notes, this extends from those on fixed incomes (retirees) if their pensions do not automatically adjust, to people with annual salary reviews (since it takes a year before their salary is revised to account for changes in the cost of living) to contractors. However, it may even extend to day labourers, if their employers are not able to adjust prices frequently and pass on higher wages as a result. Having wages kept low while prices increase also benefits employers, but makes workers want to change jobs in order to lock in a higher wage rate. This 'employee churn' imposes costs on the employer as well as the economy overall.

Inflation imposes costs on people. New Zealanders may have forgotten about these costs (or never experienced them if they are young), but that doesn't make those costs any less real.

[HT: Marginal Revolution]