Imagine that we took a poll and asked people the following question.This year the yard is 36 inches. How long do you think it should be next year? Assuming we could get people to take us seriously, they would tell us that the yard should stay the same length-36 inches. Anything else would just complicatelife needlessly.

What does this finding have to do with inflation? .Recall that money, as the economy’s unit of account, is what we use to quote prices and record debts. In other words, money is the yardstick with which we measure economic transactions. The job of the Federal Reserve is a bit like the job of the Bureau of Standards-to ensure the reliability of a commonly used unit of measurement. When the Fed increases the money supply and creates inflation, it erodes the real value of the unit of account.

It is difficult to judge the costs of the confusion and inconvenience that arise from inflation. Earlier, we discussed how the tax code incorrectly measures real incomes in the presence of inflation. Similarly, accountants incorrectly measure firms’ earnings when prices are rising over time. Because inflation causes dollars at different times to have different real values, computing a firm’s profit-the difference between its revenue and costs-is more complicated in an economy with inflation. Therefore, to some extent, inflation makes investors less able to sort out successful from unsuccessful firms, which in turn impedes financial markets in their role of allocating the economy’s saving to alternative types of investment.


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