Macro- Unit 2- Cost of Inflation

Menu costs

Menu costs are the costs incurred by firms (businesses) when they have to change their prices. Most firms change their prices infrequently because of the costs of changing those prices. Things like: Changing the physical tags on the products. Changing the computer system to reflect new prices. Changing print materials (advertisements, signs, etc.) to show the changes. When prices change often or rapidly, these costs can start to add up - in terms of time and money - for a business.

Unit of account costs

Money is a "unit of account," which means that it helps us to determine value by allowing us to compare the worth of goods and services against one another. -When prices change often or rapidly, it makes it more difficult for consumers, business, and workers to gauge the costs and benefits of their actions. -To give an analogy, imagine a tailor being asked to sew a suit using a tape measure that is elastic. Or, another analogy, using a watch that constantly fluctuates between being 5 to 20 minutes off of the actual time. -A large part of our day is spent trying to determine the best ways to use our time and money. -Fluctuating prices make this more difficult and time-consuming.

Explain the difference between nominal interest rate and real interest rate.

-A nominal interest rate is the percentage return on a loan calculated using current dollars. In other words, it is the rate the bank states that you are earning or paying. -A real interest rate is the percentage return on a loan calculated using purchasing power. In other words, it is the rate you are actually earning or paying when distortions of inflation are removed.

In what two ways can rising prices be viewed?

-Buyers of goods and services PAY MORE for what they buy. -Sellers of goods and services GET MORE for what they sell. (Remember that, in the factor market, workers SELL their labor. Therefore, increases in prices often go hand-in-hand with increases in income, keeping purchasing power relative stable in this regard.)

The anticipated costs of inflation can be grouped into three broad categories:

-Shoe-leather costs -Menu costs -Unit of account costs

Shoe-leather costs

-Shoe-leather costs refer to the time and effort people take to minimize the effects of inflation on purchasing power. (time is our most valuable and scarce resource) In other words, inflation affects the amount of time people spend managing their money and financial assets to ensure they lose as little purchasing power as possible. (spend right away vs. save with interest(interest offset loss of purchasing power))

Who are possible groups of people hurt by inflation?

1. People on fixed incomes 2. Lenders 3. Business with long-term contracts. 4. Savers

Two important ways inflation can affect our lives?

1. Wages 2. Interest Rates

How are people engaged in contracts affect by inflation?

A business in a contract is hurt by inflation. (Example- 5 year contract at today's price)

Explain the difference between nominal wage rate and real wage rate.

A wage is the amount of money we get for our work. The nominal wage rate is the average hourly wage rate measured in current dollars. In other words, it is the dollar amount on your paycheck. The real wage rate is the average hourly wage rate measured in real dollars. In other words, after we remove the distortions of inflation, it's the actual purchasing power you walk away with.

So why do we worry about inflation?...

Because inflation does have a cost and those costs can be different depending on which group you are talking about.

Why do inflationary periods test to hurt lenders and help borrowers?

Because loans are often paid back in inflated dollars. (Example- $10 from bank to buy bread- 10 loaves...)

What is COLA (used my many employers and government programs --like SS)?

COLA stands for cost-of-living adjustment (or cost-of-living allowance) and it raises a wage when the consumer price index rises.

How are people on fixed incomes hurt by inflation?

If someone's income stays "fixed" (constant) and prices rise all around him are going up, his money will not go as far.

How are savers hurt by inflation?

If the money you invest does not grow as fast as inflation, it will have less purchasing power when you take it out of the investment.

Because of the disparity between nominal and real wages, what do we often rely on to correct theses differences?

Indexation -- which is the automatic correction of a dollar amount for the effects of inflation by law or contract. Basically, as prices rise, wages will automatically increase to compensate for the inflation (in an attempt to keep the real wage rate constant or nearly-constant).

What is the formula for real interest rate?

Real interest rate = nominal interest rate- the inflation rate.

How to you convert nominal wages to real wages?

Real wage rate in Year 1= (Nominal wage rate in Year 1 / CPI in year 1) * 100

** As price level increases, purchasing power...

decreases (though the correlation is not as simple as it first appears).

To offset the idea that lenders are hurt by inflation, how do banks counteract the affects of inflation?

using real interest rates