Macroeconomics 8: The costs of inflation

Question 1

Describe the costs of expected inflation

Answer 1

• Shoe-Leather Cost : with higher inflation you need to manage your finances more actively
• Menu Costs : The prices of goods and services need to be changed more regularly
• Relative price distortions : Since prices are not adjusted at the same time relative prices will change
  leading to resource misallocation
• Non-indexation of tax codes : Governments can raise more revenue because inflation pushes more
  households into a higher rate of tax
• Complexity : Inflation makes planning for the future more difficult and increases the probability of
  making mistakes
  Given that prices tend to be sticky in the short run it may be better to have a positive rate of inflation that
  can allow, for example, real wages to change as a result of price inflation rather than changing the nominal
  wage paid. The costs of expected inflation are very low if inflation is 1-2%.

Question 2

Describe & explain hyperinflation

Answer 2

• We now turn to an inflationary situation where the rate of inflation is so high that they lead to a
  breakdown of a monetary economy. This is the situation of Hyperinflation
• The costs of (expected and unexpected) inflation are very high in periods of very high inflation.
• Prices are changed every day or even more frequently
• The costs of holding currency are so high that individuals spend as quickly as they can (the
  demand for money goes to zero due to expected inflation increases)
• The physical costs of making transactions is increased
• Relative prices play little role in markets so resources are misallocated
• Governments suffer significant falls in real tax revenue as prices rise to erode real value of future
  tax that is paid
• The high level of uncertainty means that households and firms will reduce spending and the real
  economy contracts

Question 3

Describe & explain interest rates, expected inflation and the demand for
money in high inflation periods

Answer 3

We can write the demand for money as
M^D/P = fM(Y,i) with ∂fM/∂Y>0 and ∂fM/∂i<0
Using the Fisher equation we obtain
M^D/P = fM(Y,r+π^e)
Note that ∂fM/∂π^e<0, so as expected inflation increases, the demand for money will fall (velocity of money
rises).
In extreme cases where inflation is rising very fast then MD/P will fall to close to zero and V rises to a very high
level
So as inflation/expected inflation increases then the effects of monetary growth on prices is larger

In a diagram: Money Supply Money Demand come together -> Price Level -> Inflation Rate -> Nominal Interest Rate -> back to Money Demand