As we mentioned in the opening story, in 1980 Americans were dismayed about the state of the
economy for two reasons: the unemployment rate was high, and so was inflation. In fact, the high
rate of inflation, not the high rate of unemployment, was the principal concern of policy makers at the
time—so much so that Paul Volcker, the chairman of the Federal Reserve Board (which controls
monetary policy), more or less deliberately created a deep recession in order to bring inflation under
control. Only in 1982, after inflation had dropped sharply and the unemployment rate had risen to
more than 10%,did fighting unemployment become the chief priority.
Why is inflation something to worry about? Why do policy makers even now get anxious when they
see the inflation rate moving upward? The answer is that inflation can impose costs on the economy
—but not in the way most people think.
The most common complaint about inflation, an increase in the price level, is that it makes everyone
poorer—after all, a given amount of money buys less.But inflation does not make everyone
poorer. To see why, it’s helpful to imagine what would happen if the United States did something
other countries have done from time to time—replacing the dollar with a new currency.
A recent example of this kind of currency conversion happened in 2002, when France, like a number
of other European countries, replaced its national currency, the franc, with the new pan-European
currency, the euro. People turned in their franc coins and notes, and received euro coins and notes
in exchange, at a rate of precisely 6.55957 francs per euro. At the same time,all contracts were
restated in euros at the same rate of exchange. For example, if a French citizen had a home
mortgage debt of 500,000 francs,this became a debt of 500,000/6.55957 = 76,224.51 euros. If a
worker’s contract specified that he or she should be paid 100 francs per hour, it became a contract
specifying a wage of 100/6.55957 = 15.2449 euros per hour, and so on.
You could imagine doing the same thing here, replacing the dollar with a “new dollar” at a rate of
exchange of, say, 7 to 1. If you owed $140,000 on your home, that would become a debt of 20,000
new dollars. If you had a wage rate of $14 an hour, it would become 2 new dollars an hour, and so
on. This would bring the overall U.S. price level back to about what it was when John F. Kennedy
So would everyone be richer as a result, because prices would be only one-seventh as high? Of