Should Nations Learn to Live with Inflation?

Abstract

It is often argued that the most important costs of inflation can be substantially mitigated by indexing reforms. Yet governments in moderate inflation countries have generally been very reluctant to promote institutional changes that would reduce the costs of inflation. Capital income continues to be taxed on a nominal basis, indexed bonds are a rarity, typical mortgage contracts keep nominal rather than real payments constant, and interest is not paid on required reserves. This paper examines the welfare consequences of inflation mitigation measures in the context of dynamic consistency theories of the determination of the inflation rate. Our general conclusion is that recognizing the effects of inflation mitigation measures on the choice of the inflation rate substantially undercuts the welfare case in their favor. It is easy to construct examples in which such measures actually reduce welfare. The case for indexing measures is strongest in settings where governments already have strong anti-inflation reputations, cannot precisely control the inflation rate, and can offset the effects of unanticipated inflation without reducing the costs of anticipated inflation. Conversely, the case for inflation mitigation measures is weakest where governments lack strong reputations, can control the inflation rate, and where indexing makes it easier to live with anticipated inflation.