Costs Of Inflation

Question 1

Costs of expected inflation (μe) (5)

Answer 1

Shoe leather costs - manage finance more actively
Menu costs
Relative price distortions
Non-indexation of tax codes
Complexity (can’t be uncertainty since expected)

Question 2

Shoe leather costs

Answer 2

Higher inflation requires you to manage finances more actively.

Question 3

Relative price distortions

Answer 3

Since prices are not adjusted at the same time, relative prices will change leading to resource misallocation.

E.g if one ingredient price changes in Jan, another in August, prices change for restaurants.

Question 4

Non-indexation of tax codes

Answer 4

Fiscal drag (gov earn more revenue as inflation pushes more households into higher tax)

Question 5

Complexity

Answer 5

Inflation makes planning for future more difficult, increases probability of making mistakes.

Question 6

Costs of unexpected inflation (5)

Answer 6

Unexpected cash flows between agents (debtors or creditors lose)

Those on fixed nominal incomes negatively impacted. E.g pensioners (Real value is now less)

Uncertainty - reduce investment

Distorts relative prices - flexible prices can move, but fixed ones are forced to stay so resource allocation

Political and social unrest - damaging to economy.

Question 7

Why is unexpected inflation more costly than expected inflation

And evaluation.

Answer 7

Creates more resource misallocation.

If unexpected inflation is created to respond to a shock e.g expansionary monetary to boost demand in a pandemic, it is a good thing.

Question 8

Hyperinflation costs (6)

Answer 8

Prices change every day or more

Cost of holding currency is so high individuals spend as quickly as they can (increase V before it increases more) - demand for money goes to 0 (people don’t want to hold money) (this explains inverse relationship between V and demand for money mentioned earlier)

Physical costs of making transactions increases

Relative prices play little role in markets so resources are misallocated.

Fall in tax revenue - high prices erode real value of future tax paid. (Tax isn’t paid instantly so future tax is worth less)

Uncertainty - reduced AD

Question 9

How can we show that when expected inflation increases, the demand for money falls?

Answer 9

We start with demand for RMB
Md/P = fm (Y,i)
Meaning demand for RMB is a function of income (Y) and interest rates (i)

(Income increases, we demand more money, as interest rates increase we demand less as the opp. cost of holding money increases)

Then sub our fisher equation into i. (i=r+μe)
Md/P = fm (Y,r+μe)

Here we can see as μe increases, we reduce holding and spend (V increases) while demand for money falls.

Question 10

Quantity theory predicts what about hyperinflation?

And how?

Answer 10

Excessive monetary creation causes hyperinflation

How?
When government is unable to meet expenditure commitments (not enough tax rev)

So raises revenue by seigniorage (producing coins and notes creates an inflation tax and causing this hyperinflation)

So seigniorage causes hyperinflationi

Question 11

Example of this?

Answer 11

Germany - struggled to meet reparation payments so printed money to cover it.

Question 12

How to stop hyperinflation?

Answer 12

Control its fiscal deficit (when G>T)

Question 13

How can this fiscal deficit be reformed?

Answer 13

Currency reform, new currency created (rather than printing more of the existing) , once people believe it is stable then it will balance out.