Money Growth and Inflation (Part 2): The Costs of Inflation and the Classical Theory

Study Guide - Smart Notes

Tailored notes based on your materials, expanded with key definitions, examples, and context.

Chapter 11: Money Growth and Inflation (Part 2)

The Classical Theory of Inflation

The classical theory of inflation explains the relationship between the money supply and the price level in an economy. It is foundational for understanding how monetary policy affects inflation.

Quantity Equation: The equation that relates the quantity of money, the velocity of money, and the dollar value of the economy’s output of goods and services.

Quantity Theory of Money: This theory asserts that the quantity of money available determines the price level, and that the growth rate in the quantity of money available determines the inflation rate.

The Costs of Inflation

Inflation is closely watched and widely discussed because it is thought to be a serious economic problem. However, the actual costs of inflation are more nuanced than commonly believed.

A Fall in Purchasing Power? The Inflation Fallacy

Many believe inflation lowers the purchasing power of income, but this is not necessarily true if nominal incomes rise with prices.
If nominal incomes keep pace with rising prices, real purchasing power is not reduced by inflation.
There are, however, real costs associated with inflation.

Shoeleather Costs

Inflation erodes the value of money held in cash, encouraging people to hold less money.
Holding less money means more frequent trips to the bank or more online transactions.
Shoeleather costs are the resources wasted when people try to minimize their money holdings due to inflation.
Examples: Frequent bank visits, more price monitoring, and increased shopping trips.

Menu Costs

Firms change prices infrequently because changing prices is costly.
During inflation, firms must change prices more often, increasing these costs.
Menu costs refer to the costs of changing prices, such as printing new menus, updating catalogues, and communicating new prices to customers.
Examples: Cost of printing new price lists, sending updates to dealers, advertising new prices, and handling customer complaints about price changes.

Inflation-Induced Tax Distortions

Inflation raises the tax burden on income earned from savings because taxes are levied on nominal, not real, interest income and capital gains.
This discourages saving, as the real after-tax return is reduced.
The income tax system often does not adjust for inflation, so savers pay taxes on inflationary gains.
Example: If you buy a stock for $10,000 and sell it for $11,000 after a year with 10% inflation, your real gain is zero, but you are taxed on the $1,000 nominal gain.

Table 11.1: How Inflation Raises the Tax Burden on Saving

This table compares the effects of inflation on the after-tax real interest rate in two economies: one with price stability and one with inflation.

	Economy A (price stability)	Economy B (inflation)
Real interest	4%	4%
Inflation rate	0%	8%
Nominal interest rate (real interest rate + inflation rate)	4%	12%
Reduced interest due to 25% tax (0.25 × nominal interest rate)	1%	3%
After-tax nominal interest rate (nominal interest rate – tax)	3%	9%
After-tax real interest rate (after-tax nominal interest rate – inflation rate)	3% – 0% = 3%	9% – 8% = 1%

Additional info: This table demonstrates that higher inflation reduces the after-tax real interest rate, discouraging saving.

Active Learning: Tax Distortions

Scenario: Deposit $1,000 in the bank for one year, with a 25% tax on interest income.
Case 1: Inflation = 0%, nominal interest rate = 10%
Case 2: Inflation = 10%, nominal interest rate = 20%
Questions:
- In which case does the real value of your deposit grow the most?
- In which case do you pay the most taxes?
- Compute the after-tax nominal interest rate, then subtract inflation to get the after-tax real interest rate for both cases.

Active Learning: Answers

In both cases, the real interest rate is 10%, so the real value of the deposit grows 10% (before taxes).
Taxes paid:
- Case 1: Interest income = $100, taxes = $25
- Case 2: Interest income = $200, taxes = $50
After-tax nominal and real interest rates:
- Case 1: , real =
- Case 2: , real =

Active Learning: Summary and Lessons

Inflation raises nominal interest rates (Fisher effect) but not real interest rates.
Inflation increases savers’ tax burdens and lowers the after-tax real interest rate.
A solution is to index the tax system to inflation.
Historical note: In the 1970s, the Canadian income tax was not indexed to inflation, causing real salaries to fall. Indexation was introduced in 2000.

Confusion and Inconvenience

Inflation makes it harder to compare nominal values from different time periods, complicating long-term financial planning.
Examples:
- Parents planning for future college expenses
- Individuals planning for retirement
- CEOs deciding on long-term investments

Quick Quiz

Ongoing inflation does not automatically reduce most people’s incomes because:
- a. the tax code is fully indexed for inflation.
- b. people respond to inflation by holding less money.
- c. wage inflation goes together with price inflation.
- d. higher inflation lowers real interest rates.