What are the true costs of inflation?
Inflation does not erode real wages.
Inflation does not favor borrowers at expense of lenders if inflation is anticipated.
i=r+Einflation (Fisher equation
unexpectedly high, inflation helps borrowers, if
inflation lower than expected, lenders win)
Other costs of inflation:
inflation tax – all inflation, whether anticipated or not, reduces real value
of CASH holdings
if I keep $50,000 in mattress, and inflation is 10% in 2009, then the
real value of that cash falls by 10%
can avoid inflation tax by keeping wealth in interest-bearing assets
(bank accounts, CD’s, money market mutual fund, etc.) Inflation will
be reflected in i paid by such accounts, so wealth protected from
How important is it? Cash is minor % of wealth in US so inflation tax
not that important
More important where cash was key in people’s portfolios: poor
people in US, less developed counties today, earlier periods of
history, underground economy (mob).
Menu costs – firms pay to change nominal prices, higher when inflation is
high (change catalog and aisle prices)
Shoe leather costs – during high inflation people spend more time
shopping for low prices, go to banks more often.
Hyperinflation = > 10% per month.
In Europe during/following
Latin America 1980s-19990s
What is the Classical Model of the economy? Popular before 1930a
1. Society produces on its PPF each period (never inside)
PPF shows max. amount of Y economy can produce for given leisure
(aggregate economy’s resource + technological constraints)
2. Resources in economy are always FULLY EMPLOYED each period:
Actual UR=natural rate
Does not assume everyone works long hours 365 days a year
Assumes we produce as much Y as technologically possible, given
desired leisure time
3. Business cycles can be caused by supply and preference shocks
Supply shocks (shifts in PPF)
Favorable example: inventions, new resource energy, internet
developed in 1990s making economy more productive, can
produce more Y for given level of leisure.
PPF shifts up
ii. Unfavorable: droughts, natural disasters, oil embargoes, 1973
OPEC limits oil production, recession
Preference shocks (movements along PPF)