Inflation as a Redistribution Shock: Effects on Aggregates and Welfare

Inflation surprises area salient characteristic of modern economies. Throughout most of the inflation episode experienced by the United States along with other industrialized countries in the 1970s, realized inflation exceeded prior expectations.1 More generally, inflation volatility emerges as a key stylized fact in Fischer, Sahay, and Vegh (2002), a detailed study of more than 200 postwar high-inflation episodes in 92 countries. Surprise inflation redistributes wealth from lenders to borrowers by reducing the real value of nominal assets and liabilities. This redistribution effect is not taken into account inmost existing research on the welfare cost of inflation, which employsa representative-agent framework (see, for example, Lucas 2000 and the references therein). This study analyzes the effects of inflation asa redistribution shock, that is, an unanticipated wealth transfer between different sectors and groups of households. In particular, we quantify the aggregate and welfare effects of a hypothetical ten-year inflation episode on the U.S. economy, assuming that the only real effects of inflation are due to the reval- uationofnominal assets and liabilities. The resulting welfare effects on individual co- hortseasily outweigh conventional measures of the welfare costs of inflation. Moreover, the weighted welfare of domestic households improves—the opposite of what standard monetary models predict. Redistribution alone also generates effects on economic aggregates that areas large as those in representative-agent models with monetary frictions. Another difference from standard models is that the effects of redistribution persist long after the end of an inflation episode. Surprise inflation affects households not only directly by changing the value of their nom- inalpositions, but also indirectly through changes in fiscal policy. Fiscal policy must adjust in some dimension during an inflation episode, since the reduction of real govern- mentdebtpresents the government with a windfall gain. We use our model to illustrate how the welfare impact on households depends on how this gain is spent. For example, we describe one policy scenario under which amajority coalition that includes all but the richest households benefits from a surprise inflation episode. The young net borrowers in the coalition benefit directly, while the government uses its gain to compensate old net lenders through higher social security transfers. Under this policy, the bill is paid by rich old households and the foreign sector. The result suggests that the temptation for policy makers to inflate might be greater than is commonly thought download.