Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Menu costs

Imagine that you run a business that prints a catalogue of its prices for different goods and services (a restaurant menu is an obvious example). Without inflation, your life would be relatively simple: print the catalogue once and then use the same one for a long period of time. Whether customers buy something today or in ten years doesn’t matter; the prices won’t have changed!

Of course, even with no inflation and prices not rising on average, some items may still fall in price and others rise. But even then you probably don’t have to update your prices that often. Contrast this with the case where inflation is, say, 10 per cent. Now, if you don’t update your prices, the real price of your goods will fall by 10 per cent every year. Unsurprisingly, prices are updated much more often in countries experiencing high levels of inflation.

The time, effort and cost of continually having to update your prices due to inflation are called the menu costs of inflation.

Other costs

Here are some more costs of inflation:

Relative price distortions: Linked to the idea behind menu costs, if some

firms are changing their prices and others aren’t, relative prices change from their ‘true’ value. So, for example, the ‘true’ relative price of milk versus eggs might be that 4 pints of milk costs the same as 6 eggs.

Inflation means that milk and egg manufacturers should both increase their prices.

But perhaps only the milk manufacturer increases its price, so that now 3 pints of milk = 6 eggs. Economists call this situation a distortion, because relative prices no longer reflect the correct trade-off between goods.

Arbitrary redistribution of wealth: Because almost all contracts are set using nominal prices, inflation can arbitrarily redistribute between two parties in a contract. For example, if you take out a loan at a time when inflation is expected to be low, but inflation turns out to be high, the real value of your repayments to the lender will fall. Similarly, if you take out a loan when inflation is expected to be high and it turns out low, your real repayments increase.

The same applies to wage contracts – if inflation is unexpectedly high, the real wage falls. Although one party always benefits when the other party loses, economists consider this situation to be costly to both parties, because it makes them more uncertain about the future.

Planning for the future becomes difficult: High and volatile inflation causes problems, because how much money will be worth in the future in real terms isn’t clear. As a result, retirement planning is especially difficult.

Imagine that you plan your retirement carefully to ensure that you have exactly £2,000 per month. You’re meticulous and 30 years later you achieve your goal, only to find that the money doesn’t go nearly as far as you’d imagined in your youth.