If you ask the typical person why inflation is bad, he will tell you that the answer is obvious: Inflation robs him of the purchasing power of his hard-earned dollars. When prices rise, each dollar of income buys fewer goods and services. Thus, it might seem that inflation directly lowers living standards.

Yet further thought reveals a fallacy in this answer. When prices rise, buyers of goods and services pay more for what they buy. At the same time, however, sellers of goods and services get more for what they sell. Because most people earn their incomes by selling their services, such as their labor, inflation in incomes goes hand in hand with inflation in prices. Thus, inflation does not in itself reduce people s real purchasing power.

People believe the inflation fallacy because they do not appreciate the principle of monetary neutrality. A worker who receives an annual raise of 10 percent tends to view that raise as a reward for her own talent and effort. When an inflation rate of 6 percent reduces the real value of that raise to only 4 percent, the worker might feel that she has been cheated of what is rightfully her due. In fact, as we discussed in the chapter on production and growth, real incomes are determined by real variables, such as physical capital.

If nominal incomes tend to keep pace with rising prices, why then is inflation a problem? It turns out that there is no single answer to this question. Instead, economists have identified several costs of inflation. Each of these costs shows some way in which persistent growth in the money supply does, in fact, have some effect on real variables.

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