What are the costs of inflation? Which is most important? How about deflation? Would that be a problem and for whom? The FRB worries more about deflation. Why? Do you agree? Why or why not
Our textbook discusses six different costs of inflation.
The costs of inflation include “shoe leather” costs which are when your resources are wasted dealing with the changes in price and value of a dollar. People wear down the leather in their shoes by having to make more moves to trade the volatile money for more stable currency.
There are also “menu costs” that come with changing prices. A company has to print new menus or catalogs, send all of the new costs to their distributors and spend money on people who have to deal with customers who are angry about the higher prices.
Another cost of inflation is the relative-price variability. When there is high inflation, and prices rise dramatically, the relative cost to the consumer is higher and they are less apt to buy. Although with this one, the hit at the beginning is bad and then people get used to it.
The fourth cost listed is inflation-induced tax distortions. The tax code in our country does not take into account the inflation rate on both capital gains and interest income. With capital gains, you are taxed on the entire gain of the investment, not the gain that is adjusted for inflation. With interest income, when there is a higher rate of inflation, the amount actually earned on interest is lower than with a lower rate of inflation.
Inflation can cause confusion for both accountants and investors. Accountants find it difficult to compute proper profits when inflation raises the cost to do business and investors may become confused by these numbers and choose to put their money elsewhere.
The final cost the book discusses is that inflation (and deflation) can cause a strange distribution of wealth. If a loan is made with a fixed interest rate and there is a lot of inflation, then the borrower pays “less” in the end. On the other side of this, when there is deflation, and the value of a dollar goes down, the borrower ends up paying “more” for the loan.
Deflation is bad because it is often unpredictable and still comes with its own costs. Lower prices still make menu changes necessary, the relative- price variability is affected, the redistribution of wealth makes the poor (borrower) poorer, creates lower demand for goods and services, lowers income and raises unemployment.
The Fed worries about this because deflation shows that there are deeper problems within the economy. Slow, steady inflation often shows that an economy is healthy.
My Journey into Macroeconomics 