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Macroeconomics ECO 403

LESSON 13

MONEY AND INFLATION (Continued...)

Why is inflation bad?

What costs does inflation impose on society? List all the ones you can think of.

Focus on the long run.

Think like an economist.

A common misperception

Common misperception:

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:

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:

1. Costs when inflation is expected

2. Additional costs when inflation is

different than people had expected.

Costs of expected inflation:

1. Shoeleather cost

def: the costs and inconveniences of reducing money balances to avoid the inflation tax.

↑š ⇒ ↑i

⇒ ↓ 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

def: The costs of changing prices.

Examples:

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Macroeconomics ECO 403

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.

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.

Example:

· 1/1/2001: you bought Rs100, 000 worth of ABC stock

· 12/31/2001: you sold the stock for Rs110, 000,

so your nominal capital gain was Rs10, 000 (10%).

· Suppose š = 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.

Additional cost of unexpected inflation:

Arbitrary redistributions of purchasing power

Many long-term contracts not indexed,

but based on še.

If š turns out different from še,

then some gain at others' expense.

Example: borrowers & lenders

· If š > š , then (r - š) < (r - š )

and purchasing power is transferred from lenders to borrowers.

· If š < š , then purchasing power is transferred from borrowers to lenders.

Additional cost of high inflation:

Increased uncertainty

When inflation is high, it's more variable and unpredictable:

š turns out different from še more often, and the differences tend to be larger (though not

systematically positive or negative)

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Macroeconomics ECO 403

Arbitrary redistributions of wealth

become more likely.

This creates higher uncertainty, which makes risk averse people worse off.

One benefit of inflation

Nominal wages are rarely reduced, even when the equilibrium real wage falls.

Inflation allows the real wages to reach equilibrium levels without nominal wage cuts.

Therefore, moderate inflation improves the functioning of labor markets.

Hyperinflation

def: š ≥ 50% per month

All the costs of moderate inflation described above become HUGE under hyperinflation.

Money ceases to function as a store of value, and may not serve its other functions (unit of

account, medium of exchange).

People may conduct transactions with barter or a stable foreign currency.

What causes hyperinflation?

Hyperinflation is caused by excessive money supply growth:

When the central bank prints money, the price level rises.

If it prints money rapidly enough, the result is hyperinflation.

Why governments create hyperinflation

When a government cannot raise taxes or sell bonds,

it must finance spending increases by printing money.

In theory, the solution to hyperinflation is simple: stop printing money.

In the real world, this requires drastic and painful fiscal restraint.