I Do What I Do

by Raghuram G. Rajan

But what if inflation were only 15 per cent per year? Haven’t countries grown fast over a period of time despite high inflation? The answer is yes, but perhaps they could have grown faster with low inflation. After all, the variability of inflation increases with its level, as does the dispersion of prices from their fundamental value in the economy. This makes price signals more confusing – is the price of my widget going up because of high demand or because of high generalized inflation? In the former case, I can sell more if I produce more, in the latter case I will be left with unsold inventory. Production and investment therefore become more risky. Moreover, high and variable inflation causes lenders to demand a higher fixed interest rate to compensate for the risk that inflation will move around (the so-called inflation risk premium), thus raising the cost of finance. The long-term nominal (and real) interest rates savers require rise, thus making some long-duration projects prohibitively costly. These effects kick in only when inflation is noticeably high.