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Economic Theory

the higher the rate of inflation, the more often restaurants have to print new
menus;
3) increased variability of relative prices:
for example, suppose a firm issues a new catalog every January. If there is

no inflation, then the firm’s prices relative to the overall price level are
constant over the year. Yet if inflation is 1 percent per month, then from

the beginning to the end of the year the firm’s relative prices fall by 12
percent. Sales from this catalog will tend to be low early in the year (when
its prices are relatively high) and high later in the year (when its prices are
relatively low). Hence, when inflation induces variability in relative prices,

it leads to microeconomic inefficiencies in the allocation of resources;
4) unintended changes in tax liabilities due to nonindexation of the tax
code, confusion and inconvenience resulting from a changing unit of

account:
suppose you buy some stock today and sell it a year from now at the
same real price. It would seem reasonable for the government not to levy a
tax, because you have earned no real income from this investment. Indeed,

if there is no inflation, a zero tax liability would be the outcome. But
suppose the rate of inflation is 12 percent and you initially paid $100 per
share for the stock; for the real price to be the same a year later, you must

sell the stock for $112 per share. In this case the tax code, which ignores
the effects of inflation, says that you have earned $12 per share in income,
and the government taxes you on this capital gain. The problem is that the
tax code measures income as the nominal rather than the real capital gain.

In this example, and in many others, inflation distorts how taxes are levied;
5) inconvenience of living in a world with a changing price level:

for example, a changing price level complicates personal financial
planning. One important decision that all households face is how much of
their income to consume today and how much to save for retirement. A
dollar saved today and invested at a fixed nominal interest rate will yield a

fixed dollar amount in the future. Yet the real value of that dollar amount –
which will determine the retiree’s living standard – depends on the future
price level. Deciding how much to save would be much simpler if people

could count on the price level in 30 years being similar to its level today.
One benefit of inflation. Some economists believe that a little bit of
inflation – say, 2 or 3 percent per year – can be a good thing. The
argument for moderate inflation starts with the observation that cuts in

nominal wages is rare: firms are reluctant to cut their workers’ nominal
wages, and workers are reluctant to accept such cuts. A 2-percent wage cut

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