This positive effect on resource allocation results because price signals are more easily and accurately interpreted in a low-inflation environment. Let me explain. Relative price changes provide an important guide to resource allocation in an economy. But in an inflationary environment, it may be difficult for individual decision makers to distinguish between inflation on the one hand and a change in relative prices on the other. In short, because of the confounding of price signals, resources may be seriously misallocated during inflationary periods, to the detriment of output and living standards.
Institutional arrangements add to the problems stemming from high and variable inflation.
Since the tax system is not fully indexed, inflation may adversely affect incentives to work and to invest. In the extreme, considerable resources may be wasted in efforts to avoid or to offset the ravages of inflation. And, without widespread indexation, inflation may well result in capricious transfers of wealth. All of these effects diminish when inflation is persistently low. Overall, there is little question that low inflation implies less uncertainty about the future.