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11
LONG-TERM FINANCING IN AN INFLATIONARY ENVIRONMENT
Franco Modigliani
There is a widespread view among economists that inflation is neutral, i.e. it has
only nominal but not real effects on the economy. This conclusion supposedly
derives from the well-known proposition that the real economy should be unaffected
by the level of nominal prices, it should perform in exactly the same way
with a price level twice as high or one third smaller. But if the price level does
not matter, then inflation, which is the change from one level to another, should
also have no effects on the real economy. But this conclusion is in fact quite
wrong, at least for existing economies, as is evidenced by recent experiences with
inflation.
To be sure, one can imagine an economy in which all contracts are indexed
instantaneously (and have forever been indexed). But the reason why inflation
would have no effect in this economy is that, in effect, that economy has abandoned
the use of money as the numeraire and adopted a different numeraire,
namely the “commodity basket,” in terms of which there is no inflation (though
even in this economy there would be some real effects through the demand for
money).
But in reality no system has ever been 100 percent indexed and for good
reasons, including inertia, inflation illusion, and the difficulty and cost of indexing,
especially past contracts. In the absence of total indexation, inflation has disruptive
effects on the real economy increasing with the rate of inflation. These
effects can be traced to five basic factors: (1) continuing reliance on nominal
institutions, both public and private; (2) effects of unanticipated inflation on
preexisting nominal contracts, e.g. redistribution from lender to borrowers; (3)
uncertainty of future prices; (4) inflation illusion or misunderstanding of the real
implications of nominal contracts; and finally (5) the one effect that is generally
recognized, the Keynesian money economizing syndrome.
Reprinted from Pacific-Basin Finance Journal 1 (1993), 99–104, with permission from Elsevier
Science.