ECON103 Chapter ECON103: The Costs of Inflation
The Costs of Inflation
• Economists have identified six costs of inflation: shoeleather costs associated with reduced
money holdings, menu costs associated with more frequent adjustment of prices, increased
variability of relative prices, unintended changes in tax liabilities due to nonindexation of the
tax code, confusion and inconvenience resulting from a changing unit of account, and
arbitrary redistributions of wealth between debtors and creditors. Many of these costs are
large during hyperinflation, but the size of these costs for moderate inflation is less clear.
• Shoeleather Costs: the resources wasted when inflation encourages people to reduce their
money holdings
• Menu Costs: the costs of changing prices
• Inflation-Induced Tax Distortions: Almost all taxes distort incentives, cause people to alter
their ehavior, ad lead to a less effiiet alloatio of the eooy’s resoures. Oe solutio
to this problem, other than eliminating inflation, is to index the tax system. That is, the tax
laws could be rewritten to take account of the effects of inflation.
Example-1:
According to the quantity equation and assuming velocity is constant, suppose real GDP is
growing at 2 percent and that the money supply is growing at 6 percent. What is the inflation
rate?
a.8 percent
b.0 percent
c.4 percent
d.-4 percent
Answer:
%ΔM + %ΔV = %ΔP + %ΔY
If V is constant, the inflation rate equals the growth of the money supply minus the
growth of real GDP.
Inflation rate = 6% - 2% = 4% (Option C)
Example-2:
Suppose the nominal interest rate is 5 percent and the inflation rate is 2 percent. If the real
interest rate does not change, according to the Fisher effect what will happen to the nominal rate
if inflation increases to 4 percent?
a. It will fall to 3 percent
b. It will not change
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Document Summary
Inflation-induced tax distortions: almost all taxes distort incentives, cause people to alter their (cid:271)ehavior, a(cid:374)d lead to a less effi(cid:272)ie(cid:374)t allo(cid:272)atio(cid:374) of the e(cid:272)o(cid:374)o(cid:373)y"s resour(cid:272)es. O(cid:374)e solutio(cid:374) to this problem, other than eliminating inflation, is to index the tax system. That is, the tax laws could be rewritten to take account of the effects of inflation. According to the quantity equation and assuming velocity is constant, suppose real gdp is growing at 2 percent and that the money supply is growing at 6 percent. What is the inflation rate? a. 8 percent b. 0 percent c. 4 percent d. -4 percent. If v is constant, the inflation rate equals the growth of the money supply minus the growth of real gdp. Inflation rate = 6% - 2% = 4% (option c) Suppose the nominal interest rate is 5 percent and the inflation rate is 2 percent. Answer: real rate = nominal rate inflation rate = 5 2 = 3 percent.
