Life at the zero lower bound part 2: The inflation tax

In simple terms, most economists think that inflation is not really a good thing (as do many people TH has the pleasure of knowing: older folk, like TH’s dad and father-in-law, really don’t like inflation, and it seems neither do people from Germany, and many US republicans). The reason is that when there is inflation, money will earn a negative rate of return equal to the negative of the inflation rate.  This is the typically thought of as an inflation tax on cash (both TH’s father and father-in-law have a strong preference for holding cash as an asset and hate the idea of inflation eroding the value  of their savings). But inflation is only part of the inflation tax because even if inflation is zero, you could be holding other assets, which typically have earned a positive real rate of return.  Thus, even a zero rate of inflation means that money loses value over time relative to these other assets.   If, for example, the real rate of interest on other investments such as land was, say, 5 percent, then with a zero rate of inflation, money would lose out to land at a rate of 5 percent per year.

The inflation tax is truly only zero if the inflation rate is such that the real return on money equals the real return on other assets.  In the example just given, the deflation rate would have to be 5 percent (i.e. inflation of minus 5 percent) if money was to earn the same rate of return as land.  Any inflation rate higher than that would effectively be a tax on money and induce people to hold less of it.

In simple terms, the inflation tax is equal to the real rate of return that can be earned by investing in physical assets such as land) plus the inflation rate meaning that the inflation tax is lessened by two things: 1) a fall in expected inflation, and 2) a decrease in the natural real rate of interest.

Chart 1 shows a rough and ready estimate of the trend  inflation tax for the US using the Laubach and Williams natural real rate estimates and an estimate of long run trend inflation by your truly.

US inflation tax

From the chart you see that back in the 1970s, when the natural rate of interest was about 3 to 4 percent in real terms and the expected inflation rate in the United States was about 7 percent, the inflation tax amounted to about 11 percent.   Since then, it has come down considerably.  The inflation tax is now about between 1 to 2 percent – the lowest that it has been in the last forty years or more (and if you did this for just about any other advanced country, you would find the same thing).  If you used actual inflation and the current estimate of the short-term neutral rate (i.e. one that allows for temporary weakness in aggregate demand), then the inflation tax would currently be around zero maybe even slightly negative.  This situation is a result of low inflation and a low real rate interest rates and is very much a part of life at the zero lower bound.

Torrens reckons this is interesting.  Right now, we find ourselves in what according to Milton Friedman’s optimal quantity of money, is an almost perfect monetary equilibrium – where the inflation tax is zero and we hold just the right amount of cash.  Is this an unexpected silver lining of our times? Or could it possibly be a cause of our economic woes?

TH is not sure, but he is sure that this phenomenon is important and certainly warrants thinking about more because it raises all sorts of questions.  For example, perhaps the Federal Reserve’s balance sheet, which has expanded significantly from $869 billion on August 8, 2007, to almost $4.5 trillion, is now just as it should be.  Maybe the problem was that in the years leading up to the crisis, the amount of Federal Reserve liabilities was just too small (relative to the amount of leverage in the banking system for example).

Thinking of grumpy old men and taxes …





2 thoughts on “Life at the zero lower bound part 2: The inflation tax

    1. So nice to hear from you DPK.
      The only real point that TH wants to make here is that right now, the inflation tax is at the lowest level in our lifetime. So holding cash is not expensive. That doesn’t mean you should fill your portfolio with cash — never put all your eggs in one basket. But having extra cash on hand to make day to day purchases is not a costly exercise (especially when you consider the transactions costs of using a credit card).

      It also makes you wonder about the incentives to put your money in the bank and use cheques or debit payments. They are convenient, but compared to cash, they too seem to be increasingly more costly. Much more so than in the past when an interest bearing deposit clearly trumped cash.

      Anyway, DPK. Nice to hear from you. Hope all is well.

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