In each of the following scenarios, explain and categorize the cost of inflation

Question

In each of the following scenarios, explain and categorize the cost of inflation. Because inflation has risen, the L.L. Bean Company decides to issue a new catalog quarterly rather than annually. a. b. Grandma buys an annuity for $100,000 from an insurance company, which promises to pay her S10,000 a year for the rest of her life. After buying it, she was surprised that high inflation triples the price level over the next few years. c. Maria lives in an economy with hyperinflation. Each day after being paid, she runs to d, Warren lives in an economy with an inflation rate of 10% per year. Over the past year, he earned a return of S50,000 on his million dollar portfolio of stocks and bonds. Because his tax rate is 20%, he paid $10,000 to the government.

Explanation / Answer

a. In this case, the cost of inflation is the "Menu Cost." With new catalog being issued on a quarterly basis as compared to an annual basis, the overall cost of catalog publication increases.

b. In this case, Grandma will experience a "Loss in Purchasing Power." The reason is that as inflation surges, the dollar value declines relative to increase in price of goods and services. Just as an example, a 10% return on $100 will translate into return of $110. However, if inflation is 15%, the cost of goods and services is $115. Therefore, the purchasing power declines relative to a base of $100, which was earlier used to buy "one" good or service.

c. This is known as the "Shoe-Leather Costs" and was seen in the time of hperinflation in Germany, among others. The term is used for getting rid of money as quickly as possible in order to avoid inflation tax. In hyperinflatin, purchaing power declines sharply on a daily basis and it's more beneficial to quickly convert cash into essential goods & services before cash loses value further.

d. In the given case, Warren experiences "Redistribution of Wealth." This happens when some asset prices increase slowly as compared to the general price level. In the given case, a million dollar portfolio earning $50,000 on an annual basis implies returns of 5% when inflation is 10%. On top of that, taxes need to be paid to the government.

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