Substantial Gains From Reducing Inflation

Even if we know for sure next year''s inflation rate – for example, under a credible inflation target – are we better off having lower inflation? Yes, according to Jagjit Chadha, Andrew Haldane and Norbert Janssen of the Bank of England, writing in the latest issue of the Economic Journal.

These researchers find that moving from 4% inflation to zero inflation implies a gain of around 0.2% of GNP in perpetuity, the equivalent of an annuity worth 9% of initial GNP. In 1995, that would have amounted to £60 billion, more than twice the current size of the Bank of England's balance sheet.

People seem to agree that inflation harms economies, these researchers note. And economists have generally thought that inflation reduces welfare by making it difficult for people to assess the likely rate of inflation: it is their errors in assessing future levels of inflation that reduce welfare. While that is likely to be true, this paper examines the case for welfare losses arising from fully anticipated inflation rates.

The central idea is that higher inflation makes people economise on their holdings of money balances since the inflation rate equals the negative rate of return on money balances. Money holdings affect welfare through their ability to allow economies on shopping time. The paper examines the implications for welfare arising from different potential effects of interest rate changes on desired money balances.

According to this research, the percentage change in interest rates rather than the absolute change in interest rates seems a more likely representation of people''s choices on whether to hold money or assets. Such a specification has the following implications for ''steady-state'' holdings of money: that when interest rates tend to zero, as inflation falls, the proportional change tends to infinity but the absolute change tends to zero. It is because the proportional change is so high at low interest ates that high quantities of money are held and why welfare is increased.

Although the researchers find evidence for the importance of proportional change in interest rates for the short-run adjustment of money balances, they find that long run (or steady-state) money balances seem best described by reference to absolute changes. This might be a consequence of people adjusting money balances directly to proportional changes but maintaining steady-state levels in terms of the actual return foregone on money holdings.

Use of the formulation of the absolute level of interest rates reduces the welfare gains of lower inflation as does constraining the reduction to zero rather than the Friedmanite maximum of the negative real rate of interest – that is, so that nominal interest rates are zero. Nevertheless, the welfare gain seems appealing.

''Shoe-leather Costs Reconsidered'' by Jagjit S Chadha, Andrew G Haldane and Norbert G Janssen is published in the March 1998 issue of the Economic Journal. The authors are all at the Bank of England, Threadneedle Street, London, EC2R 8AH.