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I know what relative price is and that it fluctuates more frequently in times of Inflation. But what I don’t understand is why it is called “distortion” when relative price dispersion is caused by inflation.

According to various textbooks such as Mankiw’s, relative price is what enables rational consumer decisions and effective resource allocation, but inflation leads to its “distortion” which results in resource misallocation.

Now “distortion” usually means a phenomenon that misleads people into making wrong decisions. But where does distortion exist in relative price fluctuations? isn’t it natural for people to buy more goods that increase in terms of relative price, and buy less that decrease in relative price?

I don’t understand what bad decisions people are making here, and why it leads to resource “misallocation”.

Even if there isn’t inflation, relative price fluctuation exists all the time, and consumers always make decisions based on that. We don’t really call THAT a distortion - it’s a perfectly normal thing that causes a substitution effect which makes us buy more things that are relatively cheaper. So wouldn’t decisions based on relative price usually actually lead to better resource allocation?

So my question is, what “distortion” is happening when relative price fluctuations happen from inflation, and why does that lead to “resource misallocation”? Is there an excess supply or excess demand that results from people taking action based on relative price fluctuations? If there isn’t, why is it resource misallocation?

I would really appreciate it if someone could give me a good explanation on this. I’ve tried to solve this curiousity for days searching the internet and stuff but I’ve been unable to find satisfying answers. Detailed examples would be extremely helpful :)

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  • $\begingroup$ Could you quote the specific sentences/passage/pages where inflation is described as a distortion? It might simply be that Mankiw and others use the word distortion to refer to anything that they deem "bad". $\endgroup$ – Kenny LJ Aug 24 at 7:15
  • $\begingroup$ well you can check out this slide (slideshare.net/mobile/fedjapan/…) where it says “Cost of Inflation” $\endgroup$ – Robin Aug 24 at 7:49
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The word "distortion", (as used in e.g. the Ramsey–Boiteux pricing), is not intrinsically negative.

It simply means that people change their consumption behaviour because of changes in price(s).

For example, a tax on oxygen would not (and cannot) be distortive because people have no choice but consuming oxygen.

A contrario, a tax on tabacco is distortive, and is actually precisely implemented because of this very trait: it will change the consumption behaviour of smokers.

Put differently, the notion of distortion is strongly related to the notion of price elasticity.

Also, constraining markets equilibrium can generate deadweight losses, which is likely the reason why people think of the word "distortion" as negative. Is changing behaviour via price signals negative per se? Is trying to make people quit smoking negative per se ? No.


The word "distortion" is probably one of the most misconceived/misused notion in economic theory, especially when it is used in the political sphere. But originally it has, I repeat, no negative connotation. And I really think that this is how Mankiw uses/perceives it.


Why is price dispersion from Inflation called relative price “distortion”?

It is called so because consumption behaviors do not change if all increases of prices in the economy are of the same relative magnitude $\iff$ the dispersion is null. E.g. a tax on, say, tobacco, has to be distortive to be useful, i.e. it has to be greater than inflation, even if such intervention can actually generate deadweight losses.

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  • $\begingroup$ Any question @Robin ? $\endgroup$ – keepAlive Sep 2 at 18:17

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