Writer- Shagun Khetan | Editor- Siya Kohli
Can you imagine paying a 100 billion just to buy yourself a normal lunch?
Well, it happened, and it got worse. The first decade of the 2000s was pretty terrible for Zimbabwe due to numerous economic shocks of rising national debt, production declines and political corruption. In 2008, their central bank issued notes worth 10 million Zimbabwe dollars, though worth only 4 US dollars then. Furthermore, just a year later, it issued notes worth 10 trillion Zimbabwe dollars, then worth only 3 US dollars, and eventually smaller denomination currency became worthless.
Looks REALLY terrible, doesn’t it? See for yourself.
Why did this happen?
It’s typical- Large government budget deficit led to the large-scale creation of money and resultantly high rates of inflation.
However, we know printing money leads to a fall in the value of money, and so do the governments. So why did they resort to this method?
Because it pays for their spending. A government has to incur a lot of expenses: build infrastructure, pay salaries to government officials and soldiers, help the poor by giving subsidies, etc. They usually issue bonds or levy taxes to get this money, but printing money also helps the government to pay for spending. Think about it, it’s basically a hidden tax; it is not like other taxes for which you get a bill, it just reduces the value of money you already have. When the government prints more money, the price level rises and reduces the value of disposable income. This is called the inflation tax,i.e., a tax on everyone who holds money.
Why is inflation considered a serious economic problem though? Is it really that bad?
Fall in purchasing power(typical answer) -
When prices rise, each dollar buys fewer goods and services, leading to lower standards. Give more thought to it, if buyers of goods and services pay more, then sellers of goods and services receive more. And since most people earn their incomes by selling their services, inflation in incomes goes hand in hand with inflation in prices in the long term. Why is it a problem then? Turns out there are several other costs of inflation, which show that continuous growth in money supply does have an effect on real variables too.
Remember the inflation tax? As expected, people try to avoid paying this tax. To do this, they would hold less money in their wallet because inflation decreases the value of money in their wallet. So instead of withdrawing 10,000 a month, they would withdraw 2,500 a week. By making frequent trips, they ensure they keep more money in the banks that yield interest rather than keeping it in their wallets, where inflation erodes its value.
Why is it called shoeleather costs though? Because going frequently to the bank causes your shoes to wear out more quickly. Interesting. No, don't take it literally—it’s the time and convenience that you have to sacrifice by keeping less money in hand which you wouldn’t have to if there were no inflation.
We don’t experience this much in moderate inflation, but in Zimbabwe 2008, it was a hassle for people to go immediately to the bank the second they got their paychecks to avoid losing value of money they hold because the value of the currency was going down every minute.
These are costs for price adjustment—cost of printing a new menu. Printing, circulating, advertising, dealing with annoyed customers. Economists refer to a business’s cost of changing its prices as “menu costs”, using as a metaphor the new menus that restaurants print when prices change. Again, these costs become an issue in case of hyperinflations, when it is impractical to keep constant prices when the value of the currency is going down so rapidly.
Relative price variability and misallocation of resources
Let’s say a company wants to avoid menu costs so they only change their prices once a year. Now relative prices—prices of the good to other prices in the economy, will be high towards the early months of the year and low in the later months. Higher the inflation rate, higher this variability. Why does this matter? Because people use relative prices to determine how scarce resources should be allocated. When inflation distorts these relative prices which leads to misallocation of resources.
Inflation-induced tax distortions
Taxes distort incentives, but it just becomes more problematic when there’s the cherry on the top called inflation as well. One way is how it discourages savings due to tax treatment of capital gains— you bought a stock for $10, sold it for $50 after 20 years, capital gain = $40, subject to tax. But suppose, due to inflation, you made a real gain of only $30 because $10 then is equivalent to $20 at the time of sale. Inflation exaggerates capital gains and inevitably increases the tax burden in this case.
Market prices are signals to consumers and firms–signals that help allocate resources in a market economy. Higher prices in the economy can be a result of either higher demand or inflation. If it were due to higher demand, then firms should buy more resources to reach a higher output to fulfil the excess demand; however if the price increase is only due to inflation, then firms should not change their level of output. Confusion regarding the cause can lead to misdirection of resources in the economy.
Arbitrary redistribution of wealth (among debtors and creditors)
It’s better understood by an example. Aditi took a $20,000 student loan from HDFC for 10 years at 7 percent interest which becomes $40,000 at the end of the tenure. If Aditi’s lucky, inflation will reduce the real value of the debt and she will be able to pay it back easily. In the case of deflation however, the real value of the debt rises which puts her in a risky situation because now it will be very difficult for her to pay back the loan. Also because debtors are often poorer, deflation causes a greater setback to the economy than inflation does.
These costs as mentioned are particularly significant in periods of hyperinflation, in periods of moderate inflation, it really can’t be definitively stated. Changes in the monetary policy are aimed to bring inflation under control, but that transition also affects production and employment in the short run. But that being said, costs of moderate inflation are not nearly as large as the public believes it to be.