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The Welfare Cost of Permanent Inflation and Optimal Short-Run Economic Policy

  • Feldstein, Martin S

At a minimum, this paper should serve as a warning against too easy an acceptance of the view that the costs of sustained inflation are small relative to the costs of unemployment. If a temporary reduction in unemployment causes a permanent increase in inflation, the present value of the resulting future welfare costs may well exceed the temporary short-run gain. Previous analyses have underestimated the cost of a permanent increase in the inflation rate because they have ignored the growth of the economy and therefore the growth of the future instantaneous welfare costs. In the important case in which the growth of aggregate income exceeds the social discount rate, no reduction in unemployment can justify any permanent increase in the rate of inflation. Quite the contrary, if the inflation rate is above its optimal level, the economy should then be deflated to reduce the inflation rate regardless of the temporary consequences for unemployment.

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Article provided by University of Chicago Press in its journal Journal of Political Economy.

Volume (Year): 87 (1979)
Issue (Month): 4 (August)
Pages: 749-68

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Handle: RePEc:ucp:jpolec:v:87:y:1979:i:4:p:749-68
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  1. Feldstein, Martin S & Green, Jerry R & Sheshinski, Eytan, 1978. "Inflation and Taxes in a Growing Economy with Debt and Equity Finance," Journal of Political Economy, University of Chicago Press, vol. 86(2), pages S53-70, April.
  2. Modigliani, Franco, 1977. "The Monetarist Controversy or, Should We Forsake Stabilization Policies?," American Economic Review, American Economic Association, vol. 67(2), pages 1-19, March.
  3. Fischer, Stanley, 1977. "Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, vol. 85(1), pages 191-205, February.
  4. Hall, Robert E., 1976. "The Phillips curve and macroeconomic policy," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 1(1), pages 127-148, January.
  5. Arnold Harberger, 1964. "Taxation, Resource Allocation, and Welfare," NBER Chapters, in: The Role of Direct and Indirect Taxes in the Federal Reserve System, pages 25-80 National Bureau of Economic Research, Inc.
  6. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
  7. Baily, Martin Neil, 1977. "On the Theory of Layoffs and Unemployment," Econometrica, Econometric Society, vol. 45(5), pages 1043-63, July.
  8. James Tobin, 1956. "Liquidity Preference as Behavior Towards Risk," Cowles Foundation Discussion Papers 14, Cowles Foundation for Research in Economics, Yale University.
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