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Costs of inflation

Many central banks specify price stability as their core purpose which highlights the utmost importance price stability has for an economy. It is because inflation has both explicit and implicit costs.

Expected inflation vs unexpected inflation

Expected inflation is the inflation component that economic agents expect to occur. It is what they have already embedded in their economic decisions. Unexpected inflation is the surprise component of inflation which people haven't incorporated in their pricing, costing, etc. Both components have different costs.

Shoe-leather costs

When inflation is expected, its costs include menu costs, the cost of constantly updating menus and prices, and shoe-leather costs, costs and inconvenience incurred in withdrawing cash because people would keep less cash in hand.

Costs of unexpected inflation

When inflation is unexpected, in addition to the costs discussed above, it can have potentially destabilizing effects on the economy. When inflation is greater than expected, it enriches borrowers at the expense of lenders, increases risk premium required by borrowers and other agents due to inflation uncertainty and may mislead the economic agents into believing that the increased price means increased demand (i.e. it decreases information content of prices).

MCQs

Which of the following are the least likely costs resulting from unexpected inflation?

A) Inequitable transfer of wealth from borrowers to lenders.
B) Menu costs and shoe-leather costs
C) Reduction in the information content of prices

Show answer

A is correct. Unexpected inflation enriches borrowers at the expense of lenders. B is in an incorrect choice because the cost of unexpected inflation includes all costs of expected inflation such as menu costs and shoe-leather costs. C is also an incorrect choice because inflation can be misleading when people saw an increase in price as an increase in demand.

by Obaidullah Jan, ACA, CFA on Tue Feb 11 2020

This article can help you prepare for Reading 16 LOSg.

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