Answer to Question #164266 in Economics for Susan

Question

1.suppose that the price level in Zambia is measured at 14% and is expected to rise by 3% over the next six months .

a) Explain the costs associated with this expected inflation ?

b) Explain the other costs that zambia will face if the inflation unexpectedly turns out to be 30%?

Answer 1

Since inflation does not affect real variables in the long run, the real interest rate will not change, which means that the nominal interest rate will rise in the same way as inflation. A higher nominal interest rate means that it is less profitable to hold financial wealth in the form of cash and the demand for money falls.

This means that consumers will prefer to have less money on hand, meaning they will have to visit the bank more often. This leads to an increase in the total transaction costs, or what is called, the cost of "worn-out shoes".

Another type of cost associated with inflation is called menu cost. These costs arise in connection with the need to adjust prices, and this is also associated with certain costs for changing price lists, reprinting catalogs with prices, etc.

In addition to menu overhead per se, which is unlikely to be large, there is a more serious problem that may arise as a consequence of these overheads. If we are dealing with firms with some market power, then the presence of even small menu costs can make frequent price changes unprofitable and firms will prefer to adjust prices only from time to time. The result will be distortions in the relative prices of goods, which can lead to much more serious losses than the cost of the menu itself, which caused such distortions.