2.5 Costs of Inflation

Unanticipated vs. Anticipated Inflation

Anticipated inflation is expected and can be planned for (e.g., wage contracts with cost-of-living adjustments), so its costs are smaller. Unanticipated inflation surprises people, redistributing wealth arbitrarily between borrowers/lenders and workers/employers, since contracts were set based on wrong price expectations.

Redistribution Effects

Unanticipated inflation hurts lenders/creditors and savers (paid back in dollars worth less) while helping borrowers/debtors (repay with cheaper dollars). It hurts people on fixed incomes (like pensions) whose nominal income doesn't rise with prices, reducing their real purchasing power.

Other Real Costs

Menu costs: businesses spend resources updating prices (menus, labels, systems). Shoe-leather costs: people spend time/effort minimizing cash holdings (more bank trips) to avoid inflation eroding money's value. Inflation also creates uncertainty, discouraging saving and investment, and can push people into higher tax brackets (bracket creep).

Key terms

Anticipated inflation

Expected inflation that can be planned for via contracts and adjustments, resulting in smaller economic costs.

Unanticipated inflation

Unexpected inflation that redistributes wealth arbitrarily between borrowers/lenders and workers/employers.

Menu costs

Resources businesses spend to update prices due to inflation (e.g., reprinting menus, relabeling).

Shoe-leather costs

Time and effort spent reducing cash holdings (more bank trips) to avoid inflation eroding money's value.

Effect on fixed-income earners

Inflation reduces their real purchasing power since their nominal income does not adjust with rising prices.

Try an AP-style question

Unexpected inflation tends to help…

1. workers on fixed wages
2. lenders with fixed-rate loans
3. borrowers with fixed-rate loans
4. savers with cash