David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

22.5 The costs of inflation
find that higher prices do not quite keep up with higher costs. The market has brought about the required
fall in real domestic spending, letting resources go into exports to pay for the more expensive oil imports.
People notice (a) rising prices and (b) lower real incomes, but draw the wrong conclusion. It is not the
inflation that has made them worse off, but the rise in oil prices. Inflation is a symptom of the initial refusal
to accept the new reality.
We now turn to better arguments about the cost of inflation. Our discussion has two themes. First, was the
inflation fully expected in advance, or were people surprised? Second, do our institutions, including
regulations and the tax system, let people adjust fully to inflation once they expect it? The costs of inflation
depend on the answer to these two questions.
Complete adaptation and full anticipation
Imagine an economy with annual inflation of 10 per cent for ever. Everybody anticipates it. Nominal wages
grow and nominal interest rates incorporate it. Real wages and real interest rates are unaffected. The
economy is at full employment. Government policy is also fully adjusted. Nominal taxes are changed every
year to keep real tax revenue constant. Nominal government spending rises at 10 per cent a year to keep
real government spending constant. Share prices rise with inflation to maintain the real value of company
shares. The tax treatment of interest earnings and capital gains is adjusted to reflect inflation. Pensions and
other transfer payments are raised every year, in line with expected inflation.
This economy has no inflation illusion. Everyone has adjusted to it. This explains the long-run vertical
Phillips curve in the previous section. But is complete adjustment possible?
Nominal interest rates usually rise with inflation to preserve the real rate of interest. But the nominal
interest rate is the opportunity cost of holding cash. When inflation is higher, people hold less real cash.
Society uses money to economize on the time and effort involved in undertaking
transactions. High nominal interest rates make people economize on real money
- thus incurring shoe-leather costs. Using more resources to transact, we have
fewer resources for production and consumption of goods and services.
When prices rise, price labels have to be changed. Menus are reprinted to show the
higher price of meals.
The faster the rate of price change, the more often menus must be reprinted if real
prices are to remain constant. Among the menu costs of inflation is the effort of
doing mental arithmetic. If inflation is zero, it is easy to see that a beer costs the
same as it did three months ago. When inflation is 25 per cent a year, it takes more
effort to compare the real price of beer today with that of three months ago. People
without inflation illusion try to think in real terms, but the mental arithmetic
involves time and effort.
Shoe-leather costs of
inflation are the extra time
and effort in transacting when
we economize on holding real
money.
Menu costs of inflation ore
the physical resources needed
for adjustments to keep real
things constant when inflation
occurs.
How big are menu costs? In supermarkets it is easy to change price tags. The cost of changing parking
meters, pay telephones and slot machines is larger. In countries with high inflation, pay phones usually
take tokens whose price is easily changed without having physically to alter the machines.
Even when inflation is perfectly anticipated and the economy has fully adjusted to it, we cannot avoid
shoe-leather and menu costs. These costs are big when inflation is high, but may not be too big when
inflation is moderate. However, if we cannot adjust to expected inflation, the costs are then larger.
Fully anticipated inflation when institutions do not adapt
Assume inflation is fully anticipated but institutions prevent people fully adjusting to expected inflation.
Inflation now has extra costs.
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