Friday, April 26, 2013

Inflation: What does it cost?

As I mentioned in my post about business cycles, inflation is generally (although by no means always) a sign of economic growth. Whether or not that is the case right now can be left to another post.

Today, however, I would like to talk about three down-sides associated with inflation. They are:

i. Menu costs. I've talked about menu costs before, but in case you forgot, a menu cost is essential what it costs an entity to change its prices. For example, have you ever seen that chalk-board at the local coffee shop? It's not just a cutesy effect intended to add rustic charm. The chalkboards, in fact, are intended to make it easier for the shop to change prices, easily advertise menus, etc.

If that sign was printed, in contrast, it would cost the shop to change the prices and advertise specials every time there is substantial inflation. Over time, these costs would add up.

Consider, for example, grocery stores. They actually print labels to put under the items, and every time there is major inflation, they have to print (and reprint) these labels.

ii. Shoe-leather costs. The second negative effect of inflation is what some economists refer to as 'shoe-leather costs.' The Shoe-leather effect is basically the cost to an individual trying to counter effects of inflation. When inflation occurs, many people have to make more trips to the bank which costs them energy, time, etc. Remember opportunity costs? They explain the concept of shoe-leather. This definition right now is vague at best, however I will post a more in-depth explanation later

iii. Unit of account costs. When a currency is unstable, people suffer. Unit of account costs are essentially the costs to society of having the unstable currencies (costs include time, dissatisfaction, etc). When money is constant, it is much easier to conduct business and make transactions. In fact, this is why people invest in gold.

In a sense, perhaps it is true that deflation would have the same effects. Does this mean that America should seek price stability? Let's talk about this more later.