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Costs of Inflation

Economists sometimes like to distinguish inflation into expected and unexpected inflation. Steady, predictable inflation is a feature of many developed economies and at low levels (around 3 percent for the United States) isn’t considered a cause for concern.  In fact, most of the costs listed below for expected inflation are really only a problem at high levels of inlfation.  Unexpected inflation is more of a problem, particularly for developing countries with volatile economies.

Costs of expected inflation

  1. Reluctance to hold money- Holding money as cash doesn’t earn an interest rate, and with the presence of inflation actually decreases in value over time. With inflation, people are reluctant to hold money and thus make more frequent trips to the bank (this is sometimes referred to as shoeleather costs)
  2. Increased price changing- Inflation causes firms to change their posted prices more often, the logistics of which can be costly. This is sometimes referred to as menu costs in reference to restaurants having to print new menus.
  3. Greater variability in relative prices- If firms facing menu costs don’t change prices frequently, a high rate of inflation will cause variability in real prices.  When inflation causes variability in relative prices, it leads to microeconomic inefficiencies in the allocation of resources.
  4. Distortions in the way taxes are levied- The tax code doesn’t take into account inflation so the way tax liabilities are assessed is altered from the economically efficient level.
  5. Inconvenience- Undertaking economic transactions in a world with changing price levels in inconvenient and inefficient.

Costs of unexpected inflation

  1. Arbitrarily redistributes wealth among individuals- For example loan agreements have an interest rate that has taken inflation into consideration. If inflation is higher than expected, the borrower is better off because he/she is repaying the fixed loan with less valuable dollars. The opposite situation is true if inflation is lower than expected.
  2. Hurts individuals on fixed pensions and those bound by fixed contracts- Similar to the borrower/lender example, unexpectedly high or low inflation can hurt one party in a fixed long term contract or payment system, thereby discouraging their use.

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