Costs of Inflation - Macroeconomics | Macro Economics - B Com PDF Download

Cost of Inflation

An economy which is experiencing inflation has to bear many costs and policymakers, economistsand especially politicians are concerned to make arrangements and take steps to curb inflation because of public pressure.Inflation is keenly watched and widely debated by all the stakeholders in the economy as it is considered to be a serious economic problem. Let’s study what are the costs that an economy has to face in advent of inflation.

The costs of expected inflation

If suppose, every week prices rising by half percent. What would be the cost of such predictable inflation?

1. Falling purchasing power 

When there is inflation it seems at first that now you would be able to command lesser number of goods. But is it really true? If you pay higher prices for the goods and services then the seller gets higher income and so do you when you charge higher price. So now it seems that if nominal incomes keep pace with inflation rate then fall in purchasing power is just a fallacy. Therefore, inflation itself does not lower real purchasing power of the consumer.

2. Shoe leather cost 

When an economy faces inflation, value of money is eroded. To save on that, public chooses to keep money in the banks. But how is it ensured that money is not losing its value.The solution to this isthe interest rate offered on the deposits one’s make. The nominal interest rate is at which people pay/receive interest payments to/from the commercial banks. The real interest rate is adjusted nominal interest rate for the effect of inflation in order to tell usat what pacethe purchasing power of our deposited money is growing or at least is not eroding.

Real interest rate = Nominal interest rate – inflation 

So whenever inflation is prevalent in the economy, nominal interest rate adjusts to the rate of inflation to keep the real interest rate constant. This adjustment of nominal interest rate to the inflation rate is known as Fisher effect.

Inflation creates cost on the public with regard to distortion in the amount of money they should hold. A higher inflation leads to higher interest rate via fisher effect and also lower real money balances. Then people will hold lower money balance on an average and this would mean they would make frequent trips to the bank to withdraw money. They might withdraw Rs.1000 instead of Rs.2000 once a week. This cost of wearing out of one’s shoes (while making frequent trips to banks) is metaphorically called the shoe leather cost of inflation.

3. Menu costs

Inflation also arises because high inflation causes firms to bring changes in their prices printed in menu cards more often. This procedure iscostly as it requires print and distribution of a new catalog. These costs arose due to high inflation are called menu costs, because the firms often revise the price list in their menu cards whenever the rate of inflation is high.

4. Inflation induced Tax distortions

Another factor which add to the inflation because some provisions in the tax code do not consider the effects of inflation. One of the classic examples of this is when tax laws fail to deal with inflation in case of tax on capital gains. Suppose you buy a stock today for say Rs.100 and sell it a year from now for Rs.115. It seems reasonable for the government to tax your capital gain of Rs.15(Rs.115-100). Suppose again that your economy has inflation rate of 15% over the same period. Then, in that case, you have not earned any real income from this investment.  But tax code fails to take into account the effect of inflation and government levies a tax on nominal rather than real income earned. This is how; inflation distorts tax imposition and individual’s liability.

5. Relative – price variability and misallocation of resources 

Inflation arises due to the fact that since firms face menu costs; they change prices frequently, which brings variation in relative prices. For example, McDonalds revises its menu prices in the month of January every year. If the rate of inflation is zero, then the firm’s prices relative to the overall price level are constant over the year. But if inflation is 0.5 percent per month, then at the end of the year firm’s relative prices fall by 6 percent. Firm’s prices would be relatively high early in the year and sales tend to be low.  Prices would be relatively low later in the year and sales tend to be high. Hence, inflation not only brings variability in relative prices but it also allocates the resources inefficiently.

6. Inconvenience

Another cost of inflation is the inconvenience of living in a world where prices are changing and brings changes in the value of rupee. Money is used as a yardstick for measuring economic transactions and therefore, when an economy experiences inflation, that yardstick is changing in length. Lets consider an example how changing price level complicates one’s planning about how much to save for the future. If suppose, prices were to remain same even after thirty years from now, i.e., when an individual retires. Then, a rupee saved today and invested at a fixed nominal interest rate would yield fixed rupee tomorrow. If, economy experiences inflation then real value of the investment would change and retiree’s living standard depends on the real value of the rupee. Now, individual is in a flux what to save for the retirement; since inflation could alter individual’s financial plans.