Page 179 - Krugmans Economics for AP Text Book_Neat

Increased costs of transactions caused by inflation are known as shoe -leather costs,
Shoe - leather costs are the increased
an allusion to the wear and tear caused by the extra running around that takes place
costs of transactions caused by inflation.
when people are trying to avoid holding money. Shoe -leather costs are substantial in
Menu costs are the real costs of changing
economies with very high inflation rates, as anyone who has lived in such an economy—
listed prices.
say, one suffering inflation of 100% or more per year—can attest. Most estimates sug-
Unit- of - account costs arise from the
gest, however, that the shoe -leather costs of inflation at the rates seen in the United
way inflation makes money a less reliable
States—which in peacetime has never had inflation above 15%—are quite small.
unit of measurement.
Menu Costs In a modern economy, most of the things we buy have a listed price.
There’s a price listed under each item on a supermarket shelf, a price printed on the Section 3 Measurement of Economic Performance
front page of your newspaper, a price listed for each dish on a restaurant’s menu.
Changing a listed price has a real cost, called a menu cost. For example, to change a
price in a supermarket may require a clerk to change the price listed under the item on
the shelf and an office worker to change the price associated with the item’s UPC code
in the store’s computer. In the face of inflation, of course, firms are forced to change
prices more often than they would if the price level was more or less stable. This means
higher costs for the economy as a whole.
In times of very high inflation rates, menu costs can be substantial. During the
Brazilian inflation of the early 1990s, for instance, supermarket workers reportedly
spent half of their time replacing old price stickers with new ones. When the inflation
rate is high, merchants may decide to stop listing prices in terms of the local currency
and use either an artificial unit—in effect, measuring prices relative to one another—or
a more stable currency, such as the U.S. dollar. This is exactly what the Israeli real estate
market began doing in the mid-1980s: prices were quoted in U.S. dollars, even though
payment was made in Israeli shekels. And this is also what happened in Zimbabwe
when, in May 2008, official estimates of the inflation rate reached 1,694,000%.
Menu costs are also present in low - inflation economies, but they are not severe. In
low-inflation economies, businesses might update their prices only sporadically—not
daily or even more frequently, as is the case in high -inflation or hyperinflation
economies. Also, with technological advances, menu costs are becoming less and less
important, since prices can be changed electronically and fewer merchants attach price
stickers to merchandise.
Unit - of - Account Costs In the Middle Ages, contracts were often specified “in kind”: a
tenant might, for example, be obliged to provide his landlord with a certain number of
cattle each year (the phrase in kind actually comes from an ancient word for cattle). This
may have made sense at the time, but it would be an awkward way to conduct modern
business. Instead, we state contracts in monetary terms: a renter owes a certain number
of dollars per month, a company that issues a bond promises to pay the bondholder
the dollar value of the bond when it comes due, and so on. We also tend to make our
economic calculations in dollars: a family planning its budget, or a small business
owner trying to figure out how well the business is doing, makes estimates of the
amount of money coming in and going out.
This role of the dollar as a basis for contracts and calculation is called the unit-of-
account role of money. It’s an important aspect of the modern economy. Yet it’s a role that
can be degraded by inflation, which causes the purchasing power of a dollar to change
over time—a dollar next year is worth less than a dollar this year. The effect, many econo-
mists argue, is to reduce the quality of economic decisions: the economy as a whole
makes less efficient use of its resources because of the uncertainty caused by changes in
the unit of account, the dollar. The unit -of- account costs of inflation are the costs aris-
ing from the way inflation makes money a less reliable unit of measurement.
Unit- of -account costs may be particularly important in the tax system, because in-
flation can distort the measures of income on which taxes are collected. Here’s an ex-
ample: Assume that the inflation rate is 10%, so that the overall level of prices rises 10%
each year. Suppose that a business buys an asset, such as a piece of land, for $100,000
and then resells it a year later at a price of $110,000. In a fundamental sense, the busi-
ness didn’t make a profit on the deal: in real terms, it got no more for the land than it
paid for it, because the $110,000 would purchase no more goods than the $100,000

module 14 Inflation: An Overview 137