Costs of Inflation

Type 1: Associated with higher levels of inflation

Distortions in the tax and benefits systems when not indexed
• Increases in “nominal” incomes push individuals into
higher tax brackets
• “Nominal” benefits do not keep up with inflation
• “Shoe-leather” costs
• Menu costs

Type II: Associated with unexpected changes

• Loss in real wages

• Redistribution between borrowers and lenders

s3 Functions of Money

1. Medium of exchange

2. Store of value

3. Unit of account => “money illusion”

Nominal interest rate

For each dollar borrowed, number of dollars that are repaid, expressed as percentage per year

Real interest rate

For each dollar borrowed, inflation-adjusted value of each dollar repaid, expressed as percentage per year