Costs of inflation

Costs of inflation

Central bank aims to reduce inflation at 0% and this all depends on the cost and benefits of inflation .There are four types of costs:
1. Shoe leather cost – One to one increase in inflation and nominal interest rate is fisher effect.In medium rum higher inflation leads to higher interest rate thus the opportunity cost of holding money increases and increases the trips to bank ,this is shoe leather cost.In case of hyperinflation these costs are too high.

2. Tax distortions- This cost comes from tax system and inflation .Taxes on capital gains are based on the change in price in dollars of the assets between the time it was purchased and sold.This implies higher the inflation higher will be the tax distortions.

3.Money illusion-When people choose different assets or deciding how much to save and how much to consume ,they have to keep track of the difference between the real and nominal interest rate.Thus many people find these computations difficult and often fail to make the relevant decisions .Thus Inflation often leads people to make incorrect decision and create money illusion.

4.Inflation variability- This cost from higher inflation associated with more variation in inflation and more variable inflation means financial assets bonds ,which promise a fixed nominal payments in future become riskier.With constant inflation we came to know the real value of our money exactly but with variation in inflation ,the real value will remain uncertain .For those who have invested in bonds lower inflation ,they expected better retirement but high inflation leads to poverty.
These costs are considered while targeting inflation rate to 0%.

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