Lesson 13
MONEY AND INFLATION (CONTINUED)
A COMMON MISPERCEPTION
A common misperception about inflation is that inflation reduces real wages. This is true only
in the short run, when nominal wages are fixed by contracts. In the long run, the real wage is
determined by labor supply and the marginal product of labor, not the price level or inflation
rate.
THE CLASSICAL VIEW OF INFLATION
The classical view states that a change in the price level is merely a change in the units of
measurement. So why, then, is inflation a social problem?
THE SOCIAL COSTS OF INFLATION
The social costs of inflation fall into two categories:
x Costs when inflation is expected
x Additional costs when inflation is different than people had expected.
COSTS OF EXPECTED INFLATION
1. SHOE LEATHER COST
This is the costs and inconveniences of reducing money balances to avoid the inflation tax.
As nS ni p real money balances.
Remember: In long run, inflation doesn’t affect real income or real spending. So, same
monthly spending but lower average money holdings means more frequent trips to the bank to
withdraw smaller amounts of cash.
2. MENU COSTS
This is the costs of changing prices. For example, Print new menus, print & mail new catalogs.
The higher is inflation, the more frequently firms must change their prices and incur these
costs.
3. RELATIVE PRICE DISTORTIONS
Firms facing menu costs change prices infrequently. For example, suppose a firm issues new
catalog each January. As the general price level rises throughout the year, the firm’s relative
price will fall. Different firms change their prices at different times, leading to relative price
distortions, which cause microeconomic inefficiencies in the allocation of resources
4. UNFAIR TAX TREATMENT
Some taxes are not adjusted to account for inflation, such as the capital gains tax. For
example, on, 01/01/2001: you bought Rs100, 000 worth of ABC stock. On 12/31/2001: you
sold the stock for Rs110, 000. So your nominal capital gain was Rs10, 000 (10%). Suppose S
= 10% in 2001. Your real capital gain is Rs 0. But the govt. requires you to pay taxes on your
Rs1000 nominal gain!!
5. GENERAL INCONVENIENCE
Inflation makes it harder to compare nominal values from different time periods. This
complicates long-range financial planning.
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