‘This Arbitrary Rearrangement of Riches’: an Alternative Theory of the Costliness of Inflation
Date
2007-05
Authors
Coleman, William
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Canberra, ACT: Centre for Economic Policy Research (CEPR), The Australian National University
Abstract
This paper develops a model of the costliness of inflation that places the locus of costs in
the bond market, rather than the money market. It argues that inflation is costly on
account on the contraction of the bond market caused by the riskiness of inflation. The
theory is premised upon the social function of bond markets as consisting of the
transference of technological risk from those economic interests where risk is most
concentrated (and so most painful) to interests where it is less concentrated (and so less
painful). Using a Ramsey-Solow model with decision-makers maximising expected
utility from consumption and real balances, the paper argues that unpredictable inflation
impedes this useful transfer in risks secured by the bond market. Unpredictable inflation
makes debt most costly when income is the most needed by debtors (since when the ex
post real interest is highest, the debtor is in consequence the poorest), and credit the most
remunerative when income is the least needed by creditors (since when the ex post real
interest is the highest, the creditor is as a consequence richest). The upshot of these
disincentives to borrow and lend is that less risk is transferred. Thus unpredictable
inflation reduces the socially beneficial transfer of risks that a bond market secures.
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Keywords
inflation cost, inflation risk, debt
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Working/Technical Paper
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Open Access
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