Question

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.

1. Wages of computer scientists always rise because our economy needs more and more computer scientist over time.
2. A grandpa talked to his grandson, “When I was young, everything was so cheap. Now everything is too expensive.”
3. Mary does not want to lend money to Simon even though Simon will pay her an interest rate of 3% per year.
4. Tom does not like withdrawing money from an ATM as he always forgets the password.
5. Frankie can make a huge gain if she sells her house, but she is not willing to do so.
6. Carlos sells pizzas. He has kept the prices constant for 3 years even though CPI has been increasing tremendously.

Answer 1

A. Price confusion

Price confusion results in difficulty in analyzing price changes as a result of demand shifts or inflation. Here we are assuming that the rise in salaries is because of demand.

B. Money illusion

Money illusion means people dont consider inflation when thinking whether they are richer or poorer. Here gradpa is thinking just because the price was less, everything mustve been cheaper.

C. future price level uncertainty

Because Mary is not certain about the future inflation, she doesnt want to risk it even at an interest rate.

D. Shoeleather costs

Shoeleather costs are costs which people incur because they dont want to hold money as inflation is high. Tom doesnt hold money even though he forgets the password, because inflation is high.

E. Wealth redistributon

Frankie is not willing to sell because future inflation might make her poorer and the new owner richer.

F. Menu costs

Firms incur extra cost when changing prices, this is called menu costs.