The costs of inflation
Why inflation doesn't simply make people poorer, and the real costs it does impose, from shoeleather and menu costs to tax distortions and arbitrary redistribution.
FinanceEveryday economicsAbout 6 min: 3 reading, 3 practiceUpdated
General education, not financial advice.
- Explain the inflation fallacy
- Describe the costs of steady inflation
- Explain how unexpected inflation redistributes wealth, and the problems with deflation
Builds toward: Run your own money. Budget so there's room to save, spot and clear costly debt, compare savings and loan offers, and see what interest and inflation do to your money.
Everyday economics: news, prices and choices: lesson 11 of 11
- Everyday economics
- Trade-offs and opportunity cost 5 min
- Thinking at the margin and incentives 5 min
- Models and the circular flow 5 min
- Positive and normative statements 6 min
- Demand and what shifts it 5 min
- Supply, equilibrium and shifts 6 min
- What money is 5 min
- What GDP counts 6 min
- Real and nominal GDP 5 min
- Measuring unemployment 5 min
- The costs of inflation 6 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 17
What it is
The inflation fallacy. Many people think inflation is bad because it reduces their purchasing power. Mankiw explains why this is mistaken as a general rule: prices are also incomes. When prices rise, the sellers' incomes rise too, and in the long run nominal wages tend to rise with prices. So inflation does not in itself make people poorer.
But inflation does have real costs. Mankiw lists six.
Costs even when inflation is steady and expected:
- Shoeleather costs. Inflation erodes money held as cash, so people keep less of it and make more trips to the bank. The cost is the time and convenience lost, small at low inflation but large in a hyperinflation.
- Menu costs. Changing prices is costly: deciding new prices, printing price lists, telling customers. Inflation means more price changes.
- Relative-price variability. Firms change prices only from time to time, so between changes their relative prices drift. Choices become distorted, and resources are allocated less well.
- Tax distortions. Tax laws often ignore inflation. Taxes on capital gains and on nominal interest tax the part of the return that only makes up for inflation, so the real tax rate rises with inflation and discourages saving.
- Confusion and inconvenience. Money is the economy's yardstick. When its value keeps changing, it is harder to compare real incomes and costs over time, for firms and households alike.
A cost of unexpected inflation:
- Arbitrary redistributions of wealth. Loans are written in money. If inflation turns out higher than expected, borrowers repay in money worth less, so wealth moves from lenders to borrowers; if lower than expected, from borrowers to lenders. These shifts have nothing to do with merit or need.
Quick check
Tap an answer to check it.
Inflation is 3% and a saver earns 5% nominal interest, taxed at 40%. What is the after-tax real return?
- That is the real return before tax
- That is the after-tax nominal return; you still need to subtract inflation
Show answer
0%. After tax: 5% × 0.6 = 3%; minus 3% inflation = 0%.
Why it matters
Unexpected inflation is costlier than steady inflation. High inflation is usually also variable inflation, so it is hard to predict, and the arbitrary redistributions grow.
Deflation has costs too. Mankiw notes that Milton Friedman argued for mild deflation, equal to the real interest rate, which would push the nominal interest rate to zero. But falling prices bring menu costs and relative-price variability as well, and deflation usually comes as a surprise, shifting wealth from debtors (who are often poorer) to creditors. It is often a sign of deeper problems, such as falling spending and rising unemployment. Mankiw's example: in the US, prices fell 23% from 1880 to 1896, hurting indebted farmers, which became a major issue in the 1896 election.
Worked example
A loan of 10,000 for one year at 7% nominal interest. Lender and borrower both expect 3% inflation, a real rate of 4%.
| Actual inflation | Real interest earned |
|---|---|
| 3% (as expected) | 4% |
| 6% (higher) | 1% |
| 0% (lower) | 7% |
- If inflation is 6%, the lender gets 10,700 back, but it buys only about what 10,100 did a year earlier: the lender loses, the borrower gains.
- If inflation is 0%, the lender gets a 7% real return: the lender gains, the borrower loses.
(Using the approximation real rate ≈ nominal rate − inflation.)
Common mistake
Saying inflation reduces everyone's purchasing power. In the long run, incomes rise with prices. The costs of inflation are the six listed above, not a general fall in living standards.
Key terms
- inflation fallacy
- the mistaken belief that inflation in itself reduces people's living standards
- shoeleather costs
- the resources wasted when inflation leads people to hold less money
- menu costs
- the costs of changing prices
- relative-price variability
- the drift in relative prices that occurs because prices change at different times
- capital gain
- the profit from selling an asset for more than was paid for it
- deflation
- a fall in the overall level of prices
Practise the key terms
Tap a card to turn it over. 6 cards.
| Front | Back |
|---|---|
| inflation fallacy | the mistaken belief that inflation in itself reduces people's living standards |
| shoeleather costs | the resources wasted when inflation leads people to hold less money |
| menu costs | the costs of changing prices |
| relative-price variability | the drift in relative prices that occurs because prices change at different times |
| capital gain | the profit from selling an asset for more than was paid for it |
| deflation | a fall in the overall level of prices |
Practice
Work it through
You buy a share for 100 and sell it a year later for 110. Inflation over the year is 6%, and capital gains are taxed at 20%.
- 110 − 100
- 20% × 10
- 10 − 6 (the part of the gain that beats inflation)
- 4 − 2
Quick quiz
Tap an answer to check it.
Inflation turns out higher than expected. Who gains?
- Lenders lose when inflation is higher than expected
Show answer
Borrowers: they repay in money worth less. Loans are written in nominal terms.
Why does inflation raise the real tax on saving?
- The point holds even with unchanged tax rates
Show answer
Taxes fall on nominal gains and interest, including the part that only makes up for inflation. Tax laws often ignore inflation.
Why does Mankiw call the purchasing-power argument a fallacy?
- Inflation has real costs; this argument just isn't one of them
Show answer
Prices are also incomes; in the long run incomes rise with prices. Rising prices raise sellers' incomes too.
Sort it
Which group does this belong to?
More frequent trips to the bank
Shoeleather costs arise even when inflation is expectedShow answer
Steady inflation. Shoeleather costs arise even when inflation is expected
Printing new price lists
Menu costsShow answer
Steady inflation. Menu costs
A lender repaid in money worth less than both sides expected
An arbitrary redistributionShow answer
Only unexpected inflation. An arbitrary redistribution
Higher real taxes on interest
A tax distortionShow answer
Steady inflation. A tax distortion
In short
- Inflation doesn't in itself make people poorer: prices are also incomes.
- Costs: shoeleather, menu costs, relative-price variability, tax distortions, confusion.
- Unexpected inflation redistributes wealth between borrowers and lenders.
- Deflation also has costs and is often a symptom of deeper problems.
Mastery check
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What are shoeleather costs?
Show answer
The time and convenience lost when people hold less money because inflation erodes it.
If inflation is lower than expected, who loses?
Show answer
Borrowers, who repay in money worth more than expected.
By how much did US prices fall from 1880 to 1896, according to Mankiw?
Show answer
23%.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 17.
- On this site: The quantity theory of money and Real and nominal interest rates.
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