What do people want when they sign a nominal contract?

If you ask economists about the long-term costs of inflation, they’ll give you a bewildering array of responses: there are the inefficiently low money balances caused by departure from the Friedman rule, the losses from increased price dispersion when prices are sticky, the interaction with capital gains taxes, and so on. If you switch the discussion to the short run, they’ll talk about how stabilizing inflation can be an instrument for broader macroeconomic stabilization as well.

If you ask regular people, you’ll get a very different set of answers. To them, inflation is costly because it hurts savers and retirees on fixed incomes. (though it helps anyone with a big mortgage!) More precisely, inflation redistributes wealth from people owed money on a nominal contract to people who owe money.

Regular people are a little confused on this issue. Redistribution isn’t the result of inflation per se; rather, it’s the result of unexpected inflation. If everyone expects that the inflation rate over the next 30 years will average 5%, that expectation will be built into the interest rates charged on mortgages and the returns on pension plans. An unanticipated increase in inflation tomorrow will hurt anyone with a nominally fixed income today, but a long-term increase in inflation won’t distress retirees 50 years from now.

Regular people do, however, have a valid point: the fact that so many contracts are written in nominal dollars means that stabilizing expectations about those dollars is very important. Beyond the classic concerns about macroeconomic stabilization, this gives us an additional reason to keep inflation consistent: we don’t want everyone writing a nominal contract to bear unnecessary risk.

But as I’ve pointed out in another context, there’s no single rate of “inflation”. Indeed, there are many price indexes that we could target. If we’re keeping inflation stable for the sake of people who write nominal contracts, we need to know what kind of stabilization they’re interested in. And that is not at all clear.

In fact, this is where economics starts to face some severe limitations. Ordinarily, economists determine what people want from what they do: if you have a burning desire for ice cream, you’re probably going to buy some ice cream. But if households and businesses are signing nominal contracts when they could (in theory) make those contracts contingent on some kind of price index, it’s hard to know what they’re after. At most, we know that the uncertainty cost from inflation is not high enough to overwhelm the implicit costs (whatever they may be) of including inflation in the contract. We don’t know what everyone would do if it was costless to hammer out a contract that included every little contingency.

And there isn’t any answer that’s obvious from first principles. Consider a consumer borrowing money from a bank, where repayment is specified in nominal terms. Maybe that consumer wants stability in the amount that her repayments can buy; if so, we’ll want to target the CPI. But maybe that consumer is more interested in stability relative to what she can afford; in that case, we’ll want to target nominal wages. Which is it? I don’t know. It’s probably a mix of the two.

At the very least, it’s not obvious that the answer is the CPI. And that’s all the more reason why fixating on the CPI is unnatural and counterproductive.

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5 Comments

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5 responses to “What do people want when they sign a nominal contract?

  1. Andrey

    Nice Post. I think expected versus unexpected inflation is the key concept relating to monetary policy that non-economists don’t understand.

  2. Scott Sumner

    Good post. For purposes on lender/debtor fairness, and for purposes of macroeconomic stabilization, targeting nominal wages or NGDP/capita is better than the CPI.

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  5. ed

    “But maybe that consumer is more interested in stability relative to what she can afford; in that case, we’ll want to target nominal wages.”

    I think you are missing something big here. Most of the uncertainty in my wages in 10 years is not captured in indexes of aggregate wages, it’s due to the idiosyncracies of my own career. And you can’t contract on MY wages specifically without introducing lots of moral hazard or asymmetric info problems.

    On the other hand, the CPI probably captures quite well what I am able to “afford” to buy for a nominal dollar in 10 years (with the exception of housing, which has tremendous local variation.)

    So it’s not clear which index will give a better measure of what I will be able to afford to buy with a week’s earnings in 10 years.

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