What does unexpected inflation cost

Inflation costs: The 6 costs of inflation explained in simple terms

There are 6 different inflation costs. They differ according to whether they were correctly anticipated or not. Some inflation costs can be avoided within both groups. We present the 6 inflation costs and their characteristics.

There is a close connection between inflation and the money market. In order to be able to adequately describe the cost of inflation, one must therefore briefly examine the basic properties of money.

The first property of money describes its function as a means of calculation. According to neoclassical assumptions, money has no influence on the real economy. So it can't lead to inflation either.

But if the two functions “medium of exchange function” and “store of value function” are taken into account, things look very different. The inflation costs then not only occur but can also be quantified. Because money loses its function as a store of value and then as a medium of exchange as a result of inflation. This has an impact on the real economy. The cost of inflation can be quantified based on changes in the economy (e.g. production, income, etc.).

Background inflation costs

A distinction is made between 6 different inflation costs. For the assessment of these costs, however, it is important because of the inflation they occur.

The type and amount of costs differ depending on whether the economic agents were able to correctly anticipate inflation or not. In particular with correctly or fully anticipated inflation, many of the 6 types of costs can be avoided or at least reduced.

Correctly or incompletely anticipated inflation

Not avoidable:

Shoe sole costs

Menu costs

uncertainty (reducible)

Misallocation (reducible)

Taxes (reducible)

Avoidable: Redistribution

Unexpected or incompletely anticipated inflation

Adjustment costs due to confusion

There is a relationship between the level of inflation and its predictability. It can therefore be assumed that additional costs arise from incorrectly anticipated inflation. These are especially the redistribution effects. The remaining costs, such as misallocation, tax distortion and confusion, shoe soles and menu always occur. However, they differ in their amount, depending on how well the inflation was calculated.

1. Shoe sole costs

Shoe sole costs: Maps the resources that are wasted when people reduce their cash holdings due to inflation.

In principle, inflation acts like a tax on the holding of money as it loses its real value. The real value of money falls with inflation by the level of the inflation rate.

The economic agents therefore try to avoid this “inflation tax”. With correctly anticipated inflation, this is quite possible. Because here the (nominal) interest rates rise as a reaction. The economic subjects therefore try to carry as little money as possible with them and instead to leave it in the account.

As a result, they have to go to the bank more often.

The costs caused by frequent bank visits are referred to as "shoe sole costs". However, these costs do not include the expired shoe soles but the time and inconvenience that has to be expended for this.

In principle, the shoe sole costs are economic transaction costs that arise as a result of inflation.

It can be argued that in times of technical progress and online banking, these costs are no longer significant. However, high inflation rates are no longer primarily a problem in the advanced economies. In countries with insufficient infrastructure, these can be high inflation costs.

2. Menu costs

While the shoe sole costs represent the costs for the demand side, the menu costs are the costs incurred by the company.

In general, companies rarely change their prices (or at regular intervals). Because the price changes incur costs for them. The term “menu costs” has become established for the associated costs.

Menu costs represent the costs that a company has, e.g. for printing and distributing new price lists / catalogs. Or, in a broader sense, the costs associated with price changes, such as dealing with reactions from customers and suppliers.

Inflation now increases corporate menu costs. In economies with a low inflation rate, price adjustments can be made once a year, for example, and are therefore part of a corporate strategy.

However, if the inflation rate is high, the prices have to be adjusted several times a year.

The level of these costs also depends on whether inflation has been correctly anticipated. If this is the case, companies can estimate the amount of menu costs and include them in the planning. Overall, however, menu costs are of little importance for the economy.

3. Adjustment costs due to confusion

To explain these somewhat vague costs, one must once again recall the function of money as a unit of account. With this function, money expresses prices or can quantify debts.

Money is the yardstick with which we measure economic transactions!

And the money must reliably fulfill this measuring function. It is, for example, the task of the ECB to ensure this with an appropriate monetary policy. For example, if it increases the money supply, this also leads to inflation. Money as a unit of account thus loses its real value.

In general, it is difficult to measure the cost of inflation due to confusion and inconvenience. Accountants, for example, do not properly measure corporate income when there is inflation. Because the real value of the measured money differs depending on the point in time. The profit calculation (income - costs) of a company is therefore much more difficult in an economy with inflation.

These measurement difficulties and their implications include the cost of inflation due to confusion and inconvenience.

The vague costs can have far-reaching consequences: If investors cannot correctly assess the company's value due to inflation-related measurement difficulties, they refrain from investing.

If this behavior accumulates, the financial markets can no longer properly fulfill their function: to channel macroeconomic savings to alternative types of investment.

4. Variability in relative prices and misallocations

In a market economy, the relative prices are responsible for the allocation of scarce resources (e.g. the production factors labor and capital, but also time). Companies or consumers make their respective (purchase) decisions based on comparisons of quality and price. This is how they decide how to divide up their scarce resources. Inflation now distorts these relative prices. Accordingly, the decisions made by economic operators are no longer correct. They thus lead to false calls or, in the event of inflation, an efficient allocation of resources via the is no longer possible because the price mechanism fails.

Commonly known are these three examples of misallocation leading to inflation costs:

1.) Investments: If households and companies cannot correctly anticipate inflation, they will hesitate to invest in the long term. You would then rather avoid high risks than accept possible losses.

2.) Information function of the price: Inflation leads to a reduction in the information / control function of price. In the case of inflation, consumers can no longer distinguish whether the increased price is due to inflation or whether the company is intent on making a profit.

3.) Risk and uncertainty: Risk premiums are negotiated for long-term contracts in the event of inflation. In the case of incorrectly anticipated inflation, high resources have to be used for this. However, one cannot hedge against every risk of inflation. The uncertainty and the associated costs therefore always persist to a certain extent.

5. Tax distortion caused by inflation

Taxes have the property that they give people incentives to change their (economic) behavior. In doing so, they independently lead to an economically inefficient allocation of resources.

Inflation exacerbates this problem. Because tax laws often ignore the effects of inflation. There are studies that suggest that inflation increases the tax burden on income generated through high savings.

The main reason is that the tax burden is increasing due to inflation, although the real tax base remains constant. So-called "sham profits" are taxed. In other words, profits or income that would not exist without inflation.

These gains are made when assets are sold for a purchase price that exceeds their value. So there are fictitious profits. If it is taxed, this leads to a long-term reduction in real capital formation due to a loss of assets.

Inflation leads to higher (nominal) interest rates (see the Fischer equation). Economic operators' propensity to save increases as a result. Income tax now regards nominal interest income as income. Although part of the increased interest rate covers inflation. So in this case too, “fictitious profits” are taxed. With the corresponding negative consequences.

6. (Arbitrary) redistributive effects

Inflation costs resulting from redistributive effects differ from the types of costs discussed above. Because redistribution costs do not have to arise with correctly anticipated inflation. In any case, they arise in the event of incorrectly anticipated inflation. Because inflation leads to a redistribution of wealth that has nothing to do with performance or needs. There is also a connection between the level of the average inflation rate and its variability. Economies with a high rate of inflation also often have to bear the surprising inflationary costs of the redistributive effects.

The main reason for wealth redistribution through inflation is that borrowing is in excess of nominal amounts. There are always winners and losers in inflation, as we show with the following three examples:

1.) If inflation is incorrectly anticipated, the debtors win and the creditors lose. Because the nominal claim is now worth less in real terms. For example, the state benefits from inflation because its debt financed through loans has now (in real) decreased.

2.) Labor market: Prices (through inflation) rise faster than nominal wages. As a result, workers lose to inflation because they now have lower real wages. On the other hand, companies win because they have lower costs in real terms. The redistribution therefore goes in favor of profit income.

3.) Recipients of nominally fixed transfer income are worse off (e.g. pensioners, ALGII recipients) if no timely adjustment is made. However, this effect can be prevented by indexing. It should not be forgotten here that the inflation-related distributional effects are generally politically undesirable.

  • A distinction is made between six different inflation costs.
  • The six costs vary according to whether they are the result of correctly / fully or incompletely anticipated inflation.
  • Redistribution costs only occur when inflation is not anticipated. They lead to inflation winners and losers.

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