2.5 - Costs of Inflation
Inflation vs. Purchasing Power
If prices, wages, and wealth all doubled overnight together, your actual purchasing power wouldn’t change at all. So inflation itself isn’t what’s destructive, it’s the rate and unevenness of it. In reality, some prices rise fast, some rise slowly, and some might even fall at the same time.
Arbitrary Redistribution of Wealth
Inflation doesn’t hit everyone equally, so some people benefit while others get hurt, especially when inflation turns out different than expected. People make decisions based on expected inflation, like workers demanding a cost of living raise to keep pace with a predicted 5% increase.
If inflation ends up higher than expected:
- People harmed (those receiving fixed payments): workers locked into a fixed contract lose purchasing power since prices outrun their wages, and lenders get repaid in dollars worth less than what they lent out.
- Savers and people on fixed incomes lose too: cash, a savings account with a fixed interest rate, or a pension that pays the same dollar amount every month all buy less than expected. Payments that adjust automatically for inflation, like Social Security, are mostly protected.
- People who benefit (those paying fixed amounts): employers effectively pay less in real terms, and borrowers repay loans with dollars that buy less than before.
So unexpected inflation arbitrarily shifts wealth from one group to another.
Example: a bank lends $1,000 for one year at 8% interest, expecting 3% inflation, so it expects a real return of about 5% (). If inflation turns out to be 7%, the real interest rate is only about 1% (). The borrower pays back $1,080, but those dollars buy only a little more than the original $1,000 did. The borrower wins and the bank loses.
If inflation ends up lower than expected, or prices actually fall (unexpected deflation), it flips:
- People who benefit: lenders and people receiving fixed payments. With the same loan, if prices fall 2%, the bank’s real return jumps to about 10% ().
- People harmed: borrowers, who repay with dollars worth more than the ones they borrowed. Their debt gets harder to pay off in real terms, so they often cut back on spending. When lots of borrowers do this at once, unexpected deflation can make a recession worse.
Expected inflation does much less damage, since people plan for it: lenders build it into the interest rate, and workers build it into their wage contracts. It’s the surprise that moves wealth around.
Other Specific Costs of Inflation
- Shoe leather costs: the extra transaction costs that come from rapidly rising prices. During Germany’s 1923 hyperinflation, workers were paid as often as twice a day and had to sprint to the store immediately, literally wearing out their shoes. Today it just means people change their behavior in response to high inflation.
- Menu costs: the resources spent updating prices, like printing new menus or price tags. This pulls resources away from actually productive activities.
- Unit of account costs: inflation messes with money’s role as a way to compare the value of different goods. High inflation quickly erodes the shared understanding of what a dollar amount is actually worth, making comparisons less reliable.
Confusing Market Signals
Inflation sends mixed signals to everyone. If a price rises, producers have to guess whether it’s because people genuinely want more of the product, or because the money supply grew and everyone’s just spending more across the board. That distinction matters a lot for deciding whether to ramp up production.
Takeaway
The real damage from inflation isn’t a general price rise on its own, since wages would adjust to offset that. It’s unexpected inflation, which arbitrarily redistributes wealth from lenders and fixed-wage workers to borrowers and employers. On top of that, high inflation brings non-monetary costs: shoe leather costs, menu costs, and unit of account costs.