MAcro CHAPTER 2.5:

CHAPTER SUMMARY

The main effect of inflation is that it reduces the value of each dollar, reducing the purchasing power of people and businesses. However, there are other costs of inflation as well:

• Menu Costs: The costs of having to change prices. The name "menu costs" comes from the idea that, if a restaurant wants to change its prices due to inflation, it has to pay to reprint all new menus. In other businesses, this might look like making new price tags, or hiring a team to determine what the new prices should be.

• Shoe Leather Costs: When there is high inflation, it is bad to hold cash earning zero interest, because you are essentially losing money, so people and firms want to minimize how much cash they hold. The costs (or opportunity costs) of doing so are called shoe-leather costs. This is because, before online banking, people would have to walk to the bank more often to take money out of the interest-earning savings account when inflation was high because they didn't want to take a lot of money out at once. All this walking would wear out the leather in their shoes, hence the name "shoe-leather costs." These are becoming less and less important in a world of instant, online banking.

In addition to these costs, unexpected inflation can also affect borrowers and lenders. Usually, when a borrower and a lender set up a contract, the interest rate is made up of two things:

1) The real interest rate that the lender wants to receive

2) The expected inflation rate over the course of the loan

For example, if I am lending you $100 for 1 year, if I think the inflation rate is going to be 10% during that year, I obviously wouldn't be very happy to lend you money at a 5% interest rate, because after getting my $105 back, I would have less purchasing power than when I started. So I would take the 5% increase in purchasing power that I want, and add the 10% expected inflation, to get a total of 15% as the interest rate that I will charge you for the loan.

Sometimes, though, we guess the inflation rate incorrectly. Imagine the actual inflation rate turned out to be 50%, instead of 10%. The borrower will be very happy because, while they have to pay back $105, that's worth a lot less than expected. The lender will be very unhappy because, while they do receive $105 back, it's now worth a lot less than expected.

Similarly, if the actual inflation rate turns out to be 0%, then borrower will be unhappy, because they had to pay a pretty high interest rate based on expected inflation, but the lender will be very happy since they got more real interest than they expected.

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