The Importance of Low Inflation when price changes are expected, predictable, and uniform.

The Importance of Low Inflation when price changes are expected, predictable, and uniform.

Type 1: Expected, predictable, uniform price changes.

If price changes are expected, predictable, and uniform, then their effects are relatively small. If inflation caused the prices of everything to rise at the same rate, inflation would not be so bad. It would create a few inefficiencies, however, such as the shoe leather and menu costs of inflation and an increase in the tax burden on personal investments. These costs occur with any type of inflation. What makes these costs unique, however, is that they occur even when inflation is expected, predictable and uniform.

Suppose the prices of everything in the economy double each year. Suppose wages and prices double on January 1st and remain at that level throughout the year. The week after January 1st, everyone’s income is twice as big as it was the week before. Are people better off? Because prices have also doubled, everyone’s purchasing power has stayed the same. For example, if you have $1 and a Coke costs 50 cents, then you can buy two of them. If you have $2 and a Coke costs $1, you still can buy only two of them. Your purchasing power has not changed.

The shoe leather costs of inflation

Inflation does cause people to alter their behavior, however. One form of altered behavior creates the shoe leather costs of inflation. Inflation causes people to hold less cash than in the absence of inflation. Consider the extremely high rates of inflation known as hyperinflation. If prices are increasing at a rate of 50% per month, then any cash a person carries around loses purchasing power at the same rate. If a pair of shoes costs $100 at the beginning of the month, then its price rises to $150 at the end of the month. In order to avoid the loss of purchasing power, people will tend to leave money in savings accounts where it will earn a nominal rate of interest that will keep up with the inflation rate. (Remember that nominal interest rates increase with the inflation rate.) Money loses its power as a store of value during periods of high inflation. In periods of high inflation, people have an incentive to carry less cash. This may cause them to make more frequent trips to the bank. The shoe leather costs of inflation are the wasted time and inconveniences caused when inflation encourages people to reduce their holdings of currency. The name is derived from the extra wear that would occur to people’s shoes if they walked to the bank every time they needed to withdraw cash to buy something. Modern banking conveniences, such as debit cards, have reduced the significance of the shoe leather costs of inflation.

The menu costs of inflation

Inflation also causes businesses to pay increased menu costs. The menu costs of inflation are the costs associated with changing the prices of the products sold by a business. These include the resources devoted to recalculating prices and publicizing the new prices to potential customers. The name is derived from the additional cost of printing new menus more frequently during periods of high inflation. If inflation is low, a restaurant might print new menus once or twice per year. During periods of hyperinflation, however, the restaurant might print new menus several times per week. Menu costs are significant for some businesses, such as those that rely on catalogs to generate sales.