Question

B. For each of the following separate situations, determine the associated cost of inflation.

(1) shoe-leather costs; (2) money illusion; (3) menu costs; (4) future price level uncertainty; (5) wealth redistribution; (6) price confusion; or (7) tax distortions.

(Explanations are not required)

(a) Wages of computer scientists always rise because our economy needs more and more computer scientist over time.

(b) A grandpa talked to his grandson, “When I was young, everything was so cheap. Now everything is too expensive.”

(c) Mary does not want to lend money to Simon even though Simon will pay her an interest rate of 3% per year.

(d) Tom does not like withdrawing money from an ATM as he always forgets the password.

(e) Frankie can make a huge gain if she sells her house, but she is not willing to do so.

(f) Carlos sells pizzas. He has kept the prices constant for 3 years even though CPI has been increasing tremendously.

Answer 1

1 Option d

Tom will have to visit bank to withdraw money. To save on losing interest in a bank, Tom will hold less cash and make more trips to the bank.

2 Option b

Money illusion posits that people have a tendency to view their wealth and income in nominal dollar terms, rather than recognize its real value, adjusted for inflation.Grandfather does not take into account the level of inflation in an economy, wrongly believing that a dollar is worth the same as it was the prior year.

3 Option f

Menu costs is the cost of changing price lists. When inflation is high, prices need frequently changing which incurs a cost. Carlos will have to incur menu costs if he change prices every year.

4. Option e

When inflation is high, people are more uncertain about what to spend their money on. Frank is uncertain about future prices and profits.

5 Option c

Inflation will typically make borrowers better off and lenders worse off. So, Mary will not be intrested in lending money.

6 Option e

When inflation is high, people are more uncertain about what to spend their money on. There is uncertainty and confusion about future prices. The same applies in case of Frank.

7.Option a

These costs arise because many tax laws do not take inflation into account. That is, they focus on one’s nominal rather than real income. Inflation can result in an arbitrary change in a person’s tax liability. Due to high taxes the real wages of scientists have to be increased, to increase the supply of scientists as they are very essential for economy.