Most people have some concerns about inflation, but if you asked why, responses might be vague. Typical answers include, "because prices go up," or "because my dollar won't buy as much." A period of generally rising prices is a definition of inflation, but why is it bad for the economy?
When economists discuss the costs of inflation, they have specific concerns in mind. One consequence of inflation is that it imposes "shoe-leather" costs on society. Essentially, shoe-leather costs refer to the time and effort people take to minimize the effect of inflation on the eroding purchasing power of money. People wear out their shoes on the way back and forth to the bank, so to speak, trying to protect the value of their assets.
Of course, the idea of wearing out your shoes implies more than literally walking to the bank more frequently than you otherwise would. It suggests that people spend their time and resources to manage their money and other financial assets, i.e. inflation-hedging activities, rather than using those resources to produce goods and services.
One way of thinking about shoe-leather costs of inflation relates to the interest rate's role in money demand. When inflation and expectations of inflation rise, so does the nominal interest rate.
(The nominal interest rate is composed of the real interest rate and the rate of expected inflation.) As a result of the rise in nominal interest rates, individuals hold less cash in order to keep more of their money in interest-bearing accounts. Holding less cash requires more trips to the bank thus, shoe-leather costs of inflation increase.
The costs of inflation are readily apparent during extreme episodes of inflation, known as hyperinflation. The most famous episode of hyperinflation occurred in Germany in the 1920s when prices increased 100 times from mid-1922 through mid-1923. By November 1923, the price level was more than one billion times its level in August 1922. Economists use the term "distortionary effects" to describe the impact of such a condition on the economy.
Anecdotes of the distortionary effects of the German hyperinflation include stories that workers were paid two to three times per day, rushing out to spend their pay before their money became worthless. Under these conditions, the banking system expanded and took on crucial importance—especially for those with the resources to beat the devastating effects of inflation by holding foreign currency and precious metals. The number of persons employed by German banks rose from about 100,000 in 1913 to 375,000 in 1923. Similarly, the financial sector in high-inflation Brazil during the early 1990s accounted for 15 percent of GDP (Gross Domestic Product)—much higher than in most countries.
In the United States, the increase in inflation from the 1960s to the early 1980s was also associated with an increase in the relative size of the financial sector. For example, the fraction of the labor force employed in the finance, insurance and real estate (FIRE) sector rose from about 4.6 percent in 1965 to just over 6.7 percent during the mid-1980s. The growth of this measure slowed and turned downward following the disinflation of the 1980s.
While the costs of hyperinflation are enormous and obvious, the smaller costs associated with more mild inflation are more subtle and more difficult to measure. Inflation of 10 percent, for example, results in a misallocation of resources (shoe-leather costs) that amounts to somewhere between 1 and 2 percent of GDP. Costs of an inflation rate of 3 percent are about half a percent of GDP—approximately $40 billion.
In addition, an increase in expected inflation leads people to economize on the money they hold as cash in order to keep it working in financial investments, in some cases taking extremely high risks in the hope of returns on investment that exceed the inflation rate. It is this cost of minimizing money holdings that gives rise to shoe-leather costs. Therefore, one way to measure the costs is to estimate the effects of a given rise in inflation on the demand for money.
Wearing out your own shoe leather is one thing, but to understand why economists rather than shoe cobblers are concerned, consider the effect on the economy of people's economizing on money balances, i.e. holding less cash. Leisure and work effort both decline to accommodate these inflation-hedging activities, so production also falls, and the economy contracts. In addition, there is a decrease in the stock of productive capital because inflation results in less business investment. For example, corporations are hesitant to borrow to finance new plants and equipment. Thus the effects of inflation often are considered in terms of sacrifices in economic growth.
While more apparent during periods of hyperinflation, shoe-leather costs, representing the time and effort devoted to beating inflation, can nevertheless be costly to the individual and to the economy. Keeping shoe-leather costs down is one underlying rationale of the Federal Reserve's commitment to price stability.
This article was adapted from "Shoe-Leather Costs of Inflation and Policy Credibility," which was written by senior economist Michael R. Pakko and appeared in the November/December 1998 issue of Review, a St. Louis Fed publication.