Thursday, April 23, 2009

expected inflation rate and financial decisions

expected inflation can effect the allocation of the economy is resources in three ways. First, inflation places a tax on money balances when those balances pay less than the market rate of interest. This tax is loss in purchasing power. For example, If you held $100 in currency in 1992 when the rate of inflation was about 3%, you lost $3 of purchasing power over the year. By imposing a tax on money balances, inflation reduces the public is demand for real money balances. One cost of this tax, known as shoe leather costs, is the cost to consumers and business of making more trips to the bank to avoid holding significant amounts of currency or of shifting fund from interest-bearing assets into money. when the public is shoe lather costs exceed the government is revenue gain from the inflation tax, inflation generates an "excess burden," or social loss. Stanley Fischer of M.I.T. has estimated that the annual excess burden in the UNITED STATES of a modest inflation rate of 5% is approximately 0.3% of GDP, or about $18 billion in 1992 dollars.
A second cost of expected inflation arises because the u.s. Tax system is defined in nominal terms. This definition means that the individual income tax is progressive and not fully indexed against inflation. AS a result, higher nominal incomes (for constant real incomes) can lead to a higher tax burden relative to income. this problem, called bracket creep, was particularly severe in the 1970s, when the individual income tax was more progressive than it is in the early 1990s. the failure of the tax code to adjust values of inventories and the value of depreciation allowances for inflation also raises corporate tax burdens.

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