Cost of Inflation
Department of Economics
University X
The social costs of inflation
There are two categories we need to consider:
1. costs when inflation is expected: for example we expect inflation to rise 3% every year in the future.
2. costs when inflation is different than people had expected
The costs of expected inflation
a) Shoe leather cost
Definition: the costs and inconveniences of reducing money balances to avoid inflation.
Shoe leather cost refers to the cost of time and effort that people spend trying to counter-act the effects of inflation, such as holding less cash and having to make additional trips to the bank. The actual cost of reducing money holdings is the additional time and convenience that must be sacrificed to keep less money on hand than would be required if there were no inflation.
The costs of expected inflation
b) Menu costs:
Definition: the costs of changing prices.
Examples:
• cost of printing new menus
• cost of printing & mailing new catalogs
The higher is inflation, the more frequently firms must change their prices and incur these costs.
The costs of expected inflation
c) Unfair tax treatment
Some taxes are not adjusted to account for inflation, such as the capital gains tax.
Example:
Jan 1: you buy $10,000 worth of IBM stock
Dec 31: you sell the stock for $11,000, so your nominal capital gain is $1000 (10%).
Suppose ? = 10% during the year.
¡ Your real capital gain is $0. But the government requires you to pay taxes on your $1000 nominal gain.
The costs of expected inflation
Another problem is the Fiscal Drag: When in a progressive tax system (roughly speaking a system where tax rates increases with income of tax payers), thresholds are not adjusted to take into account inflation.
The costs of expected inflation
Suppose you have a wage of £30000, and above £10000 you must pay an income tax of 20%. This means that between £0 and £10000 you don’t pay any tax; above 10000 you pay 20% of the difference between your income and the threshold £10000.
Therefore, the income tax you have to pay is: (30000-10000)0.2 = £4000.
In practice you pay (4000/30000)100 = 13.3% of your income in taxes.
The costs of expected inflation
Now suppose that there is a 10% increase in the inflation and you wage increases by 10%. This means that your real income is the same as before the price level increases.
However, assume that the threshold is not adjusted and it is still £10000.
Now your tax income is: (33000-10000)0.2 = £4600
Now you pay 4600/33000 = 13.9% of your income in taxes.
The proportion of income you pay as taxes is increased and this is called fiscal drag.
The costs of expected inflation
d) General inconvenience:
Inflation makes it harder to compare nominal values from different time periods.
This complicates long-range financial planning.
Examples:
– Parents trying to decide how much to save for the future college expenses of their (now) young child.
– Workers trying to decide how much to save for retirement.
The costs of unexpected inflation
a) Arbitrary redistribution of purchasing power.
Many long-term contracts not indexed, but based on ?e. If ? turns out different from ?e, then some gain at others’ expense. Example: borrowers and lenders.
Suppose that at time t you want to borrow some money and you need to pay back at time t+1. You need to repay the amount borrowed plus a nominal interest rate i.
The nominal interest you pay at t+1 is decided at time t when you borrow the money.The nominal interest rate depends on the inflation expected at time t+1.
The costs of unexpected inflation
Now you can have the following situation at t+1:
a) If ? > ?e, then purchasing power is transferred from lenders to borrowers. The borrower repays the loan with less valuable dollars for example.
¡ b) If ? < ?e, then purchasing power is transferred from borrowers to lenders.
The costs of unexpected inflation
For example, at time t you borrow $1000 and you agree to pay back $1000 plus a nominal interest rate of 10% at time t+1. Suppose the real interest rate is constant in both periods and known with certainty by the borrower and the lender and it is equal to 5%. This means that the lender expect an inflation rate of 5% at t+1. Now suppose that the true inflation rate at t+1 is 10%.
At t+1 you pay back $1000 + $100 = $1100.
The costs of unexpected inflation
If the lender could have expected the correct inflation rate, at t+1 you should have
paid: $1000 + ($1000)0.15= $1150.
Therefore, the lender is worse-off by the fact that his expectation was lower than the true realization of the inflation rate. On the other hand the borrower is better-off..
The costs of unexpected inflation
b) Increased uncertainty:
When inflation is high, it’s more variable and unpredictable: ? turns out different from ?e more often, and the differences tend to be larger.
Arbitrary redistributions of wealth become more likely.
This creates higher uncertainty, making risk averse people worse off.
Seigniorage
Government collects taxes. They do this in order to buy goods and services that is government expenditure.
To spend more without raising taxes or selling bonds, the government can print money (we normally say that it is the central bank that print money, but in many countries the central bank is still under the direct control of the government).
The “revenue” raised from printing money is called seigniorage.
The inflation tax:
Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money.
Why is inflation similar to a tax?
Suppose I have $500 in cash in my pocket when the government suddenly announces it has printed up enough extra dollar bills to double the economy’s cash supply. With Y and V unchanged, doubling the money supply doubles the price level. The $500 in my pocket will buy only $250 would have bought before. It is as if the government levied a special one-time 50% tax on cash holdings.