ECON 100 The Costs of Inflation

St. Charles Community College
ECON 100   Survey Economics

Question:    What’s wrong with inflation? OR Why should we worry about inflation?

Answer:      The concerns about inflation are that inflation tends to misallocate resources
                    and, thereby, distort the workings of the free market.

Let’s look at some of these distortions in further detail:


The Costs of Inflation:

I.   Erosion of purchasing power:

  • Consumer surplus is decreased.
    • However, substitution effects can kick in to minimize inflation.
    • Improved technology and production techniques can keep wages ahead of prices.
  • In extreme cases of inflation, hoarding of necessities can and does occur.
    • An example is the hoarding of rice by Chinese merchants in Indonesia in 1998 which resulted in rioting in the streets in many Indonesian cities.

II.  Spending/investing choices are changed:

  • In extreme cases, consumer/investors move money into hard assets in which prices meet or exceed the inflation rate.
    • Examples of such purchases are gold, real estate, U. S. Government Bonds (if the purchaser is overseas).
    • Extreme examples are the purchases of Volkswagen Beetles in Brazil in the 1980’s and the “fancy ladies” of Argentina and the purchases of jewelry in the 1970’s.

III.   Redistributes Income and Wealth:

  • Lender vs borrower.
    • Lenders lend out today’s dollars at today’s rates.  Borrowers pay back in tomorrows dollars but at today’s rates.
    • No one loans out money for long terms in periods of high inflation.
    • Loaners have to work harder to collect debts.
  • Fixed income vs earned income.
    • People, such as pensioners, on fixed incomes are penalized.
    • Wages generally keep up with inflation.
    • Some contracts have COLA’s included.

IV.   Higher taxes can occur during periods of high inflation:

  • High inflation causes “bracket creep.”
  • Taxes are levied on nominal profits and earnings, not on real profits and earnings.
  • Some feel that this discourages saving, lending, and investing.
    • Retards economic growth.

V.   Increased Investment Risk:

  • Expectations cause investors to hold back on new investments.
    • Investors can’t get a handle on future income flows.
    • Financing becomes more difficult when lenders fear uncertain future interest rate increases.
    • Fewer new businesses are started.
    • Contracts tend to be shorter.
      • Retards economic growth.

VI.   Administration Costs and Inefficiencies:

  • People tend to become confused in their business dealings.
  • More banking transactions are required dealing with changing inflation rates.
    • People “shopping around for better rates” cause financial institutions to have more non-productive activities.
    • Merchants spend more time modifying or updating price lists.
    • Referred to as increased “menu costs.”

VII.  Net Exports are affected:

  • When domestically produced goods generally become more expensive, exports tend to decrease and import tend to increase.
    • The exceptions are in cases where a specific country has a strong comparative advantage.
      • Examples of this are the U. S. in motion pictures and the U. S. in computer software.