The Costs of Inflation

Updated Jun 26, 2020

Inflation is a highly controversial topic because many people consider it to be a severe economic problem. After all, nobody wants their money to lose purchasing power. However, depending on the situation and type of inflation, an increase in the overall price level does not always reduce people’s real purchasing power. Nevertheless, there are five actual costs of inflation: (1) shoeleather costs, (2) menu costs, (3) relative price variability, (4) tax distortions, and (5) confusion and inconvenience. We will look at each of them in more detail below.

1. Shoeleather Costs

Shoeleather costs describe the costs people face when reducing their money holdings. That means if people carry less money in cash, they have to make more frequent trips to the bank to withdraw money. As inflation increases, people are incentivized to hold a larger share of their money in interest-bearing savings accounts instead of cash (i.e., because the interest compensates them for the loss of value). As a result, they have to visit their bank more often. These trips take time and effort, which is why they have opportunity costs.

To illustrate this, meet Joe. Joe keeps most of his money in a savings account that pays 1% annual interest. He usually withdraws USD 1,200 per month in cash to pay for groceries and other expenses. Now the inflation rate increases from 0% to 1%. As a result, the real value of the money in Joe’s wallet decreases over time. Meanwhile, the money in his savings account does not lose any real value because the 1% interest rate compensates him for the 1% inflation rate. Therefore, Joe decides to reduce his cash holdings to a maximum of USD 300 and increase the number of trips to the bank to four (instead of one). The opportunity costs of the three additional trips (including the wear and tear on his shoes) are considered shoeleather costs.

2. Menu Costs

Menu costs refer to the costs of changing prices. That means when firms change the prices of their products, they face costs because they need to communicate the new prices to consumers. These costs include the cost of printing new price lists, the cost of sending new catalogs to dealers, the cost of changing the price tags on the shelves, and so on. As inflation increases, so do menu costs. The reason for this is that rapidly increasing prices require firms to change their prices more frequently to keep up with the rising costs of doing business.

For example, think of a firm that sells shoes, we’ll call it Happy Feet Corp. This firm sets its prices at the beginning of the year. It can still make a profit if costs increase by 1%. Thus, while inflation is below 1%, setting prices at the beginning of the year is an appropriate business strategy. However, if the inflation rate increases to 2%, the firm has to change its prices at least once throughout the year to stay profitable. When that happens, it has to print new catalogs, change the price tags, and let consumers know the prices have changed. The costs associated with this additional price change are menu costs.

3. Relative Price Variability

Relative Price Variability describes the issue that consumer decisions are distorted when inflation distorts relative prices. That means while prices usually remain rather constant due to menu costs (see above), inflation causes relative prices (i.e., prices in relation to other goods and services) to vary more than they otherwise would when the overall price level changes. This, in turn, distorts consumers’ purchase decisions, because they evaluate goods and services by comparing price and quality across various products. As a result, resources may not be allocated to their best use because of inflation, and the economy becomes inefficient.

To give an example, let’s revisit our Happy Feet Corp. example from above. Suppose the firm still sets its prices at the beginning of the year. If inflation is 0%, the relative prices are equal to the prices on the products. However, if inflation increases to 6% annually, Happy Feet Corp.’s relative prices will fall by 0.5% every month (i.e., 6% annually / 12 months). As a result, the firm’s relative prices will be significantly higher at the beginning of the year than by the end of the year. Even though neither the quality nor the price tags have changed. This relative price variability makes it more difficult for consumers to correctly evaluate their best options, which can lead to a misallocation of resources.

4. Tax Distortions

Inflation-induced tax distortions refer to distorted incentives, caused by the fact that inflation tends to raise the tax burden on income earned from savings. That means many taxes don’t take the effects of inflation into account and therefore exaggerate the size of financial gains that should be taxed. Thus, inflation tends to discourage people from saving and thereby potentially slows down the economy’s growth in the long run.

To illustrate this, let’s look at capital income taxes. That is, taxes levied on the profits made by selling an asset at a higher price than its original purchase price. Suppose Joe, from our example above, bought a promising stock in 2010 at 100.00 USD per share. Today, he sells the same stock for 300.00 USD. According to the tax system, he has earned a capital gain of USD 200.00. However, if the overall price level has doubled over the same period, his initial investment of USD 100.00 from 2010 is equivalent to USD 200.00 in 2020, in terms of purchasing power. Therefore, the real capital gain (i.e., the increase in purchasing power) from selling the stock is only USD 100.00, and the capital tax is distorted.

5. Confusion and Inconvenience

Finally, inflation causes confusion and inconvenience because it affects the function of money as a unit of measurement. That means if the real value of money changes, it becomes increasingly difficult and tedious for people to measure and compare monetary values (e.g., prices, profits). Although inflation can be accounted for mathematically, its presence distorts people’s perception of value to some extent.

For example, let’s say Joe wants to invest some more money. He thinks about buying stock in Happy Feet Corp. For the sake of this example, we’ll assume that the company made a profit of USD 10 million every year for the last ten years. Although this looks pretty consistent at first glance, if the price level has increased by 1% annually over the same period, the firm’s real profits have declined every year. This may be confusing, especially for inexperienced investors, and lead to inefficient investment decisions.

Summary

Inflation is a highly controversial topic because many people consider it to be a severe economic problem. There are five costs of inflation: shoeleather costs, menu costs, relative price variability, tax distortions, and confusion, and inconvenience. Shoeleather costs describe the costs people face when reducing their money holdings. Menu costs refer to the costs of changing prices. Relative Price Variability describes the issue that consumer decisions are distorted when inflation distorts relative prices. Inflation-induced tax distortions refer to distorted incentives, caused by the fact that inflation tends to raise the tax burden on income earned from savings. Finally, inflation causes confusion and inconvenience because it affects the function of money as a unit of measurement.