The Costs and Benefits of Going from Low Inflation to Price Stability

Martin Feldstein

No 5469, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper evaluates the welfare gain from achieving price stability and compares it to the cost of the transition. In calculating the gain from price stability, the paper emphasizes the distortions caused by the interaction of inflation and capital income taxes. Because inflation exacerbates the tax distortions that would exist even with price stability, the annual deadweight loss of a two percent inflation rate is a surprisingly large one percent of GDP. Since the real gain from shifting to price stability grows in perpetuity at the rate of growth of GDP, its present value is a substantial multiple of this annual gain. Discounting the annual gains at the rate that investors require for risky equity investments (i.e., at the 5.1 percent real net-of-tax rate of return on the Standard and Poors portfolio of equities from 1970 to 1994) implies a present value gain equal to more than 35 percent of the initial level of GDP. Since the estimated cost of shifting from two percent inflation to price stability is about five percent of GDP, the gain substantially outweighs the cost of transition.

JEL-codes: E5 E6 (search for similar items in EconPapers)
Date: 1996-02
Note: PE
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Citations: View citations in EconPapers (136)

Published as Reducing Inflation: Motivation and Strategy, C. Romer and D. Romer, eds.,(Chiago: University of Chicago Press, 1997)
Published as The Costs and Benefits of Going from Low Inflation to Price Stability , Martin S. Feldstein. in Reducing Inflation: Motivation and Strategy , Romer and Romer. 1997

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