17.2 The Costs of Inflation

17.2 a. The Inflation Fallacy

By definition, inflation causes the value of an individual dollar to decrease over time. Each dollar has less purchasing power with inflation. Thus, individuals who have the same wage next year as this year will be able to purchase less. Purchasing power can be maintained if wages increase exactly at the rate of inflation, but this is not always the case. When wages increase less than the rate of inflation, people lose purchasing power [17].

Example: Let us assume that Charlie held his 10 bitcoin for the week prior to his purchase. Charlie could have purchased the acre for 1 bitcoin but a week later it cost him 10. It would appear that over the span of one week Charlie has lost 90% of the purchasing power of his 10 bitcoin. In this example, a 10x increase in monetary supply correlates to a 10x increase in price over the same period (no causation implied). So has Charlie actually lost purchasing power? [18]

^{Inflation Fallacy [19]}

17.2 b. Shoe Leather Costs

Shoe Leather cost refers to the cost of time and effort that people spend trying to counteract the effects of inflation [17].

Example: holding less cash, investing in different currencies with lower levels of inflation, and having to make additional trips to the bank [17].

^{Shoe Leather Costs [20]}

17.2 c. Menu Costs

In economics, a menu cost is the cost to a firm resulting from changing its prices. With high inflation, firms must change their prices often in order to keep up with economy-wide changes, and this can be a costly activity: explicitly, as with the need to print new menus, and implicitly, as with the extra time and effort needed to change prices constantly [17].

Example: the cost of restaurants literally printing new menus [17]

^{Menu Costs [21]}

17.2 d. Relative-Price Variability and the Misallocation of Resources

Relative-price variability is the standard deviation (or variance) of the rates of inflation of various categories of goods and services around the average consumer price inflation rate, that is, inter-market price variability [22].

Relative-price shocks can have an important impact on the public’s inflation expectations even though they are distinct from inflation. Consumers confront individual prices, not price indexes, on a day-to-day basis, and they might interpret big changes in specific prices, like gasoline or food items, as signals of emerging inflation [23].

Example: When people expect inflation, central banks can find achieving and maintaining price stability more difficult [23].

^{Price Confusion [24]}

17.2 e. Inflation-Induced Tax Distortions

In the United States, there are many taxes that do not automatically adjust for inflation. Inflation also increases the effective tax rate paid on interest income [25].

Example: Capital gains taxes are calculated based on the absolute increase in the value of an asset, not on the inflation-adjusted value increase. Therefore, the effective tax rate on capital gains when inflation is present may be much higher than the stated nominal rate [25].

^{Motor Fuel Taxes in Illinois [26]}

17.2 f. Confusion and Inconvenience

Even if prices and wages are flexible enough to adjust well for inflation, inflation still makes comparisons of monetary quantities across years more difficult than they could be [25].

Example: Given that people and companies would like to fully understand how their wages, assets, and debt evolve over time, inflation makes it more difficult [25].

^{Price Confusion [24]}

17.2 g. Arbitrary Redistributions of Wealth

Unexpected inflation can serve to redistribute wealth in an economy because not all investments and debt are indexed to inflation [25].

Example: Higher than expected inflation makes the value of debt lower in real terms, but it also makes the real returns on assets lower. Therefore, unexpected inflation serves to hurt investors and benefit those who have a lot of debt [25].

^{Redistribution of Wealth [27]}

17.2 h. Inflation is bad, but Deflation May Be Worse

Falling prices means lower revenue and profit margins for companies, which as we know leads to layoffs, less hiring, stagnant wages, and outright pay cuts. Consumers with lower incomes have less money to spend, which tends to lock the cycle in place: With sales down, firms have to cut prices even more to get business [28].

Example: If deflation were 5 percent per year and if wages fell at the same rate, a mortgage payment would take an increasingly big bite out of the paycheck [28].

^{Deflation in Japan [29]}