Question

In economics, inflation is considered as a tax. There are also various costs of inflation.

1. What is the inflation tax, and how might it explain the creation of inflation by a central bank? Explain how inflation affects savings and investment.
2. Inflation distorts relative prices. What does this mean and why does it impose a cost on the society?

Answer 1

a) The inflation tax is the increased cost of holding cash when there is high inflation. If the government prints more currency or reduces interest rates, the market is inundated with cash, which raises inflation in the long run. The higher inflation erodes the purchasing power of money ( money in hand is worth lesser) and is thus termed an inflation tax.

In periods of high inflation, the investment income and interest both suffer due to the inflation tax. So do savings. If savings do not grow as fast as inflation, a person will lose money because purchasing power goes down. The higher is the inflation rate keeping nominal interest rate constant, the lower is the real return on investment.  Inflation discourages savings.

b) Relative prices is the value of one good in terms of other goods and they provide signals about the relative scarcity of goods so goods can be allocated efficiently. When inflation rises, relative prices start varying to a greater degree as some prices change infrequently. Such changes created by inflation lead to an inefficient allocation of goods and resources because they do not signal changes in the scarcity of goods.