Monetary Policy - Inflation - Costs
Theory 1 - Anticipated inflation - did you expect it?
Anticipated inflation is where people predict correctly the level of inflation and so are able to build it into their behaviour. In this case the effects are not so great as people aren't surprised by price increases (though they'll still moan about them!) and they can allow for it in their bids for higher wages. However, there are still costs for the economy.
- Shoe-leather costs - if the value of money is falling because of inflation, then people will want to keep their money in a form earning interest for as long as possible. This means more trips to the bank to get cash, and hence the term 'shoe-leather costs'. It would perhaps be truer these days to call them 'car tyre costs', or perhaps even 'telephone costs' given the arrival of internet banking, but the expression shoe-leather costs has stuck in economic theory! Never let it be said that economic theory is behind the times!
- Menu costs - these are the costs to firms of having to constantly revise their price lists, or price labels. Higher inflation means more frequent revision of prices and this can be costly as all your customers have to be notified. The more customers you have the more expensive this is!
- Tax distortions - both direct and indirect taxes are affected by inflation. Many indirect taxes are a fixed amount. This is true of all excise duties on cigarettes, petrol and alcohol. If the amount is fixed, then inflation will gradually erode the amount the Chancellor receives in real terms. The price of the good will be going up, but the tax won't! Income tax is also affected, and in this case it's us as individuals that suffer rather than the Chancellor - much more serious! All taxpayers receive a tax-free allowance on the first part of their income. If this doesn't keep up with inflation then we will be paying more tax, even though the tax rate has not increased. See the further work section for more detail on this phenomenon which is called 'fiscal drag'.
