Money supply measures, April 2002PowerPoint PresentationSlide 3Slide 4Slide 5The social costs of inflationThe costs of expected inflation: 1. shoeleather costThe costs of expected inflation: 2. menu costsThe costs of expected inflation: 3. relative price distortionsThe costs of expected inflation: 4. unfair tax treatmentThe costs of expected inflation: 5. General inconvenienceAdditional cost of unexpected inflation: arbitrary redistributions of purchasing powerAdditional cost of high inflation: increased uncertaintySlide 14Recent episodes of hyperinflationslide 1Money supply measures, Money supply measures, April 2002April 2002_Symbol Assets included Amount (billions)_C Currency $598.7M1 C + demand deposits, 1174.0 travelers’ checks, other checkable depositsM2 M1 + small time deposits, 5480.1 savings deposits, money market mutual funds, money market deposit accountsM3 M2 + large time deposits, 8054.4 repurchase agreements, institutional money market mutual fund balancesslide 2slide 3slide 4slide 5slide 6The social costs of inflationThe social costs of inflation…fall into two categories:1. costs when inflation is expected2. additional costs when inflation is different than people had expected.slide 7The costs of expected inflation: The costs of expected inflation: 11.. shoeleather costshoeleather costdef: the costs and inconveniences of reducing money balances to avoid the inflation tax.  i   real money balancesRemember: In long run, inflation doesn’t affect real income or real spending.So, same monthly spending but lower average money holdings means more frequent trips to the bank to withdraw smaller amounts of cash.slide 8The costs of expected inflation: The costs of expected inflation: 22.. menu costsmenu costsdef: The costs of changing prices.Examples:–print new menus–print & mail new catalogsThe higher is inflation, the more frequently firms must change their prices and incur these costs.slide 9The costs of expected inflation: The costs of expected inflation: 33.. relative price distortionsrelative price distortionsFirms facing menu costs change prices infrequently.Example: Suppose a firm issues new catalog each January. As the general price level rises throughout the year, the firm’s relative price will fall. Different firms change their prices at different times, leading to relative price distortions……which cause microeconomic inefficiencies in the allocation of resources.slide 10The costs of expected inflation: The costs of expected inflation: 44.. unfair tax treatmentunfair tax treatmentSome taxes are not adjusted to account for inflation, such as the capital gains tax. Example:1/1/2001: you bought $10,000 worth of Starbucks stock12/31/2001: you sold the stock for $11,000, so your nominal capital gain was $1000 (10%). Suppose  = 10% in 2001. Your real capital gain is $0. But the govt requires you to pay taxes on your $1000 nominal gain!!slide 11The costs of expected inflation: The costs of expected inflation: 55.. General inconvenienceGeneral inconvenienceInflation makes it harder to compare nominal values from different time periods.This complicates long-range financial planning.slide 12Additional cost of Additional cost of unexp ectedunexp ected inflation: inflation: arbitrary redistributions of purchasing powerarbitrary redistributions of purchasing powerMany long-term contracts not indexed, but based on e.If  turns out different from e, then some gain at others’ expense. Example: borrowers & lenders •If  > e, then (i  ) < (i  e) and purchasing power is transferred from lenders to borrowers.•If  < e, then purchasing power is transferred from borrowers to lenders.slide 13Additional cost of high inflation: Additional cost of high inflation: increased uncertaintyincreased uncertaintyWhen inflation is high, it’s more variable and unpredictable:  turns out different from e more often, and the differences tend to be larger (though not systematically positive or negative) Arbitrary redistributions of wealth become more likely. This creates higher uncertainty, which makes risk averse people worse off.slide 14Recent episodes of hyperinflation Recent episodes of hyperinflation slide