In this video we will consider the costs and consequences of inflation.
These will help form your analysis of the impact of inflation on society and an economy.
We’ll start by looking at two costs.
Firstly, shoe leather costs and I’ll follow it up with an explanation of menu costs.
The origin of the term is that during periods of high inflation, people will end up taking
more trips to the bank to withdraw cash and as a result, wear out the leather on their
shoes.
Of course today you can access cash much easier, but the basic principle still holds true.
Shoe leather costs are associated with the costs of the time and energy spent trying
to limit or counter the effects of inflation.
This could be due to the fact that they withdraw their money from Bank X and deposit it in
Bank Y who is offering greater returns.
It could also be changing from cash to different assets that yield higher returns.
The term originates from the idea that restaurants had to adjust their menus regularly when prices
were rising rapidly.
The cost of printing new menus with the updated prices was the menu costs.
I’m currently living in China and sometimes, when I visit a local restaurant, I’ll notice
the owner has placed a sticker over the old price.
Sometimes they do this on multiple occasions.
On a wider scale, large businesses also face significant costs in updating their prices.
They have to coordinate price changes across their different geographical outlets and also
have to involve staff in managing their pricing database.
In addition to the costs of inflation, we must also consider the consequences of inflation.
I’ll explain them one by one to ensure you have the understanding you need to analyse
them thoroughly.
During periods of higher than expected inflation, income is redistributed from lenders to borrowers.
If I borrow $100 from you today with the promise to pay it back a year from now, it will have
the same purchasing power as long as there have been no changes in the price level.
If the price level has doubled, then the $100 I pay you back is worth $50 relative to the
time at which you lent it to me.
Banks charge interests rates based on an expected inflation rate and when it is higher than
expected, they lose out.
If the bank wants to make 3% on a loan and believes the inflation rate will be 4%, they
will charge 7% on the loan to account for inflation.
However, if inflation turns out to be 10% for the same period, they will lose out.
They should have charged 13% to minimise any losses.
However, due to the unexpected rise in inflation, they will absorb the loss.
The borrower gains and the lender loses.
During periods of unexpected inflation, workers will notice that their wages have lower real
purchasing power.
They are more likely to demand higher wages, which could result in even further inflation.
If this is widespread throughout the economy, worker wages will rise but potentially cause
inflation itself, resulting in an inflationary spiral.
As a country’s price level rises relative to others, it’s exports become less attractive
foreign buyers.
They will choose to buy goods and services from other countries as they will appear to
be relatively cheaper.
Additionally, domestic consumers will find imports more price competitive and choose
to purchase them over domestically produced goods and services.
When uncertainty exists within an economy, businesses face greater difficulty with future
planning.
They may limit investment plans or hold back on expansion in response to uncertainties
about the economy.
If you’re unsure why this is, put yourself in the shoes of a business owner.
If prices are changing rapidly, you will have a difficult time anticipating your production
costs as well as how your customers will adapt to economic changes.
It becomes more difficult to commit to decisions with so much volatility.
That wraps up this video on the costs and consequences of inflation.
By now you should have gained a better understanding of the impact of inflation on an economy.
Use the information provided here to build your analysis of the harm inflation can cause.
As always, I hope you’ve found this video helpful.
If you have any questions or comments, please leave them below, email me at enhancetuition@gmail.com
or tweet me @enhancetuition.
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That’s us done for now, and I will see you in the next one!