Wize AP Macroeconomics Textbook > Money and Prices in the Long Run
Costs of Inflation
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Costs of Inflation
Costs of Inflation:
1. Shoeleather Costs - the resources wasted when inflation encourages people to reduce their money holdings.
Example: Instead of withdrawing $200 from your account every month, maybe you will withdraw $50 every week to allow your money to sit in the account and earn interest. This creates an inconvenience because you have to go to the bank more often.
2. Menu Costs - the costs of changing prices. Menu costs include the cost of deciding on new prices, the cost of printing new price lists and catalogues, the cost of sending these new price lists and catalogues to dealers and customers, and the cost of advertising the new prices.
Example: A restaurant printing new menus because inflation has caused them to raise the price of their food.
3. Relative price variability and the misallocation of resources - when the restaurant prints its new menu due to inflation, its menu will seem more expensive at the start of the year and relatively cheaper at the end of the year. As there's more variability, consumers will have to keep adjusting what goods to buy. This can lead to markets not allocating resources to their best use.
Example: There will be less workers at the restaurant that raised its prices at the start of the year (because demand for that restaurant decreases) and more workers at the end of the year (once customers realize that all the other restaurants increased their prices also).
4. Inflation induced tax distortion - This is when inflation causes you to pay more in taxes than you should be paying.
Example: Let's say you make a $40 capital gain (increase in stock price of $40) on your investment, but there's inflation so your $40 gain might only be worth a real value of $30. But you still have to pay tax on the $40.
5. Arbitrary redistribution of wealth - when there is a lot of unexpected inflation remember it is
bad
for lenders and good
for borrowers (because of a lower real interest). This redistributes more wealth to borrowers and less wealth to lenders. If they had a better idea of the inflation, they would be able to set nominal interest rates accordingly.Inflation and Government
Inflation tax - the revenue the government raises by creating money.
Example: if the government wants to build a new road or bridge they can do it by working with the central bank to print more money, but this causes price level to
rise
and the value of each dollar to be worth less
. So it's like people are paying a tax indirectly because the money that they have saved is worth less now and the sales tax paid on products you buy will be higher because the price of the products is higher. This causes people to hold less money as cash for shopping and invest more in assets (like bonds) to earn some interest to keep up with inflation.