Question

Suppose the rate of inflation is constant at 5% and perfectly anticipated. All nominal values (e.g. prices, wages and tax and transfer rates) are indexed to inflation. Which of the following statements is correct?

A. It will be costly for businesses to distinguish changes in the price of their products that are due to inflation or that reflect a relative price change

B. Inflation will produce costly re-distributions of wealth

C. Inflation has zero costs

D. The real income of households will be declining over time

E. Inflation has costs associated with the real resources used in updating prices

Answer 1

Sol :

Option (c) is correct [Inflation has zero costs]

Because of the following reason :

• If the inflation rate is constant (I.e 5%) and all nominal values (ie . Wages , prices, taxes and transfer rates ) indexed with the inflation which means they present value is adjusted with respect to inflation. And
• If the purchasing power of the people is remains the same in the economy (before inflation = after inflation) , it means inflation has no effect on the people. It just increases the 0's to the transaction. So, it will cost zero to the people.

For example.

In 2019 , Goods A cost is $10 and Mr. A has income is $1000. And , in 2020 Same Goods A cost is $10.5 due to inflation corresponding to the inflation rate of 5 %, income of Mr.A also rises by 5% (ie $1050) . So , effective purchasing power of Mr. A remains the same even after the inflation.