Costs of Expected and Unexpected Inflation

Expected Inflation

Expected inflation is the inflation that economic agents anticipate in the future. Expected inflation leads to “menu cost,” which refers to a scenario in which businesses change their advertised prices constantly. The constant fluctuation of prices is due to inflation.

Inflation also leads to “shoe-leather cost,” which refers to the cost of time and effort (more especially the opportunity cost of time and energy) that people invest in trying to counteract the effects of inflation, such as holding less cash and having to make frequent trips to the bank.

Unexpected Inflation

Unexpected inflation is the inflation experienced that is above or below that which was expected. Unexpected inflation affects the economic cycle. It reduces the validity of the information on market prices for economic agents. Over the years, unexpected inflation impacts employment, investment, and profits.

Unexpected inflation leads to high-risk premiums and economic uncertainty. With higher uncertainty, lenders ask for a premium to compensate for the uncertainty. This leads to higher costs of borrowing, hence reducing economic activity because it discourages investments.

Differences Between Expected Inflation and Unexpected Inflation

In a summary, the differences can be represented in the table below:

$$
\begin{array}{l|c|c}
\text{} & \text{Expected Inflation} & \text{Unexpected Inflation} \\
\hline
1 & \begin{array}{c} \text{It is anticipated inflation by} \\ \text{economic agents in an} \\ \text{economy} \end{array} & \begin{array}{c} \text{It is inflation experienced that is} \\ \text{above or below what was expected} \end{array} \\
\hline
2 & \begin{array}{c} \text{Wage negotiations and} \\ \text{pricing into business and} \\ \text{financial contrasts solve} \\ \text{expected inflation} \end{array} & \begin{array}{c} \text{When inflation is higher than} \\ \text{expected, borrowers benefit at the} \\ \text{expense of lenders because of the} \\ \text{decline in the value of their} \\ \text{borrowing. When inflation is lower} \\ \text{than expected, lenders benefit from} \\ \text{the borrowers because of the rise in} \\ \text{the value of the payment of a debt.} \end{array} \\
\hline
3 & \begin{array}{c} \text{Menu cost and shoe leather} \\ \text{cost are the results or by-} \\ \text{products of this kind of} \\ \text{inflation.} \end{array} & \begin{array}{c} \text{Inequality, information asymmetry,} \\ \text{and risk premium are the by-products} \\ \text{of this kind of inflation.} \end{array} \\
\end{array}
$$

Question

Which of the following is caused by unexpected inflation (as opposed to expected inflation)?

A. Menu cost

B. Uneven distribution of wealth between lenders and borrowers

C. Both A and B

Solution

The correct answer is B.

Unexpected inflation leads to unequal distribution of wealth between lenders and borrowers where one tends to benefit at the expense of the other. In addition, unexpected inflation causes a reduction of information on market prices and risk premium on borrowing rates.

Options A and C are incorrect. It is expected inflation that leads to menu cost and shoe leather cost.

Reading 16 LOS 16g:

Contrast the costs of expected and unexpected inflation