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[Static Revision] The Cost of Inflation

 Explains
  • The Cost of Inflation

    • The inflation is considered to be bad for an economy mainly because it destroys the purchasing power of the money. When Price rise, each Rupee that you had will but less quantity of goods and services. Therefore, inflation destroys the real income of the people and makes them worse off.
    • The argument is particularly true for a country like India, which has a large informal sector and agriculture sector. Since most of the population is employed in informal and agriculture sector where minimum wage laws and social security benefits do not apply, the people in such sectors suffer the most due to inflation. The wages in these sectors are not indexed for inflation. Thus, when the price rises their wage does not rise, and they lose due to a reduction in real income on the one hand and no rise in wages on the other.

    There is also two associated social cost of inflation.

    • The Shoe Leather Cost

    Suppose in an economy the inflation is rising at the rate of 5% from the past few years. In such a case, everybody will expect the inflation to be 5% in future also. In such a case, all the economic transactions will be done adjusting for 5% inflation. In such an anticipated inflation scenario, the only cost of inflation will be shoe leather cost.

    The Shoe Leather Cost occurs because of the cost associated with holding money during inflation. Since inflation destroys the real power of money, and cash holding does not pay any interest, people will start depositing their money in banks to earn interest rate.

    The less money they hold in cash, the more they have to visit banks or ATMs to withdraw money. Since going to the bank is not free of cost both in terms of time and the transaction cost levied by banks on ATM usage, counter withdrawals, as well as the cost of travel to banks will all add to Shoe Leather Cost.

    • Menu Cost

    Menu cost is another social cost associated with anticipated inflation. The name menu cost is derived from the restaurants business. Menu cost arises because inflation makes the business change their listed price often. The change requires the firm to bear expense related to printing of new catalogues, new price list etc. they also have to incur expenditure on advertisement to inform customers about their new prices.

    Effects of Inflation on Different Sections

    Creditor/lender Debtor/Borrower Pensioner Producers Wealth Holders
    Inflation harms creditors, as they lose in real terms.

    A 1000 RS lent @ 5%, will pay an interest rate of 50. If inflation rises to 10%, the price of goods will be 1100, but after interest, the return will only be 1050.

    Inflation benefits the Debtor as they gain in real terms. Inflation harms the pensioners, if their pensions are not indexed to inflation, and loses money. They stand to gain by inflation since the price of goods and services rise faster than the cost of production as wages take time lag to react. They stand to lose due to inflation, as their real returns fall due to rise in prices.

     

    By
    Himanshu Arora
    Doctoral Scholar in Economics & Senior Research Fellow, CDS, Jawaharlal Nehru University


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