Although most people recognize that inflation is something to be avoided, the popular public perception of inflation's harmful effects can be rather vague. In response to survey questions about inflation, for example, most people express concerns about prices rising (defining inflation itself) or about how inflation somehow erodes standards of living. When economists discuss the costs of inflation, however, they have more specific concerns in mind. One general class of inflationary consequences is sometimes referred to as the "shoe-leather" costs of inflation: To avoid the erosion of their purchasing power due to inflation, people have to spend more time and effort protecting the value of their nominal assets—wearing out their shoes on the way back and forth to the bank.
Of course, this quaint notion represents a much broader and more serious problem than simply the cost of wearing out one's shoes. To protect assets against inflation, societal resources are channeled away from productive activities and toward inflation-hedging activities. These resource misallocations are readily apparent in countries that have experienced hyperinflation, the most famous episode having occurred in Germany in the 1920s. From August 1922 through November 1923, the price level in Germany increased by more than one billion times. During this hyperinflationary episode, price level increases averaged 322 percent per month.
Anecdotes of the distortionary effects of this hyperinflation abound. Workers were paid two to three times per day, rushing out to spend their pay before the money became worthless. At the pub after work, patrons ordered two beers at once in fear of the price rising before they had finished the first one. Shopkeepers posted prices as multiples of a base, changing the multiplication factor hourly after consulting with banks, which had set up phone lines to give the latest exchange rate quotes.
Of course, the effects of hyperinflation are extreme examples of the destructive effect of inflation more generally. It is not unreasonable to suppose, however, that costly distortions emerge on a smaller scale during more moderate periods of inflation.
In a forthcoming article in the Bank's Review, I examine previous efforts to quantify these costs and derive some estimates of my own. While methodologies and precise results differ, estimates generally fall into a common range. Inflation of 10 percent, for example, results in a misallocation of resources that amounts to somewhere between 1 and 2 percent of GDP (my own estimates being near the high end of that range). Even lower inflation rates can be costly. My calculations suggest that the costs of an inflation rate of only 3 percent are about a half percent of GDP—approximately $40 billion.
Some argue that the costs of eliminating inflation are substantial, so we should leave well enough alone. However, these costs are generally considered to be transitory, while the shoe-leather costs of sustained inflation represent a permanent drag on economic activity. Studies have shown that the potential temporary costs of anti-inflationary policies are more than made up for by the gains from achieving low inflation over time. Hence, the case for continued vigilance against inflation need not be based on fears of a surge of high inflation in the future, but can be justified on the basis that even low inflation environments engender "shoe-leather" costs that we should strive to avoid.