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Inflation and financial markets

  • Economics
  • Medicine
  • Political Science


Inflation causes many severe problems, most obviously by reducing the living standards of individuals on fixed incomes. But not enough attention has been paid to the way in which in- flation undermines financial markets, twisting out of shape the traditional relationships that make it possible for people to do business with one another. To call attention to this aspect of the question, we present four articles dealing with different aspects of how inflation affects the financial system. Edward S. Shaw describes the "dirty" type of inflation that has beset our economy-espe- cially by obstructing and distorting capital flows and capital accumulation-and discusses ways of cushioning or (better still) preventing such inflation. He emphasizes that inflation typically is not "clean"-that is, constant and perfectly foreseen-but rather that it operates at unstable rates on markets for output, factors and securi- ties. "Financial markets are segmented; relative financial prices are distorted; financial stocks are destroyed; and financial adaptations to dirty inflation are costly and inefficient." Money and government securities are demoted from the category of "safe" assets, thus destroying port- folio balance, since the accumulation of safe assets is no longer complementary with the accumulation of productive or risky assets. Many other distorting effects of this type can be cited. Shaw argues that we cannot very well live with inflation because "this disease of the price 3 system becomes worse when treated with benign neglect." Thus, ways must be found of either "cleansing" or preventing this disease. One ob- vious correction for inflationary distortions is to turn old prices loose-removing price floors or ceilings-to find their "market" level. Be- cause of the objections raised to this procedure, corrections are sometimes imposed by govern- ments in the form of indexing, with individual wages, prices and interest rates linked with some market-basket index of free prices. But since indexing a

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