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‘This Arbitrary Rearrangement of Riches’: an Alternative Theory of the Costliness of Inflation

CollectionsANU Centre for Economic Policy Research (CEPR)
Title: ‘This Arbitrary Rearrangement of Riches’: an Alternative Theory of the Costliness of Inflation
Author(s): Coleman, William
Keywords: inflation cost
inflation risk
debt
Date published: May-2007
Publisher: Canberra, ACT: Centre for Economic Policy Research (CEPR), The Australian National University
Series/Report no.: Discussion Paper (Centre for Economic Policy Research (CEPR), The Australian National University): no. 553 (May 2007)
Description: 
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.
URI: http://hdl.handle.net/1885/45283
ISBN: 1 921262 24 9
ISSN: 1442-8636

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