Which of the following best describes how inflation can impose significant costs and adversely affect economic agents through shoe-leather costs and menu costs?

• A. By lowering interest rates and encouraging excessive investment
• B. By increasing government spending and reducing private sector output
• C. By reducing the purchasing power of money and causing unemployment
• D. By increasing the frequency with which people must make trips to the bank and forcing firms to frequently update prices

Answer: (D)

Verified step by step guidance

1. Step 1: Understand the concepts of shoe-leather costs and menu costs in the context of inflation. Shoe-leather costs refer to the increased costs and inconvenience that people face when they try to avoid holding money that is losing value due to inflation, often by making more frequent trips to the bank or ATM.
2. Step 2: Recognize that menu costs are the costs incurred by firms when they have to frequently change their prices in response to inflation. This includes printing new menus, updating price lists, and the administrative burden of changing prices.
3. Step 3: Analyze how inflation leads to these costs. When inflation is high, the real value of money decreases quickly, so people want to hold less cash and more interest-bearing assets, which means more frequent bank visits (shoe-leather costs). Similarly, firms must adjust prices more often to keep up with inflation, incurring menu costs.
4. Step 4: Compare the given options to the definitions and effects of shoe-leather and menu costs. The correct description should highlight the increased frequency of bank trips and the need for firms to update prices frequently due to inflation.
5. Step 5: Conclude that the best answer is the one stating that inflation increases the frequency with which people must make trips to the bank and forces firms to frequently update prices, as this directly relates to shoe-leather and menu costs.