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Setting aside the effects that occur when one product rises in price more than another, there are two categories of effects due to increases in the price level generally. The first group of effects are caused by expected inflation. These effects are a result of the inflation economists and consumers anticipate and plan on year to year. The second group of effects are caused by unexpected inflation. These effects are a result of inflation above and beyond what was expected by economists and consumers. In general, the effects of unexpected inflation are much more harmful than the effects of expected inflation.
Expected Inflation
The major effects of expected inflation are simply inconveniences. If inflation is expected, people are less likely to keep their money in checking or savings accounts that earn minimal interest, since over time this money loses value due to inflation. Instead, people will put their money into some investment vehicle that earns a higher rate of return. This can be a bit of a nuisance, since people need money to take care of business. Thus, if consumers expect inflation, they are likely to hold their money in a less conveniently accessible form and will end up going to more trouble to retrieve it as needed. Effects like this are called shoe leather costs, in reference to the days when people would walk to the bank to make withdrawals.
The other major inconvenience of expected inflation is imposed on firms that publish the prices of their goods and services on menus, in printed catalogs, and on websites. When expected inflation makes the real value of the dollar fall over time, firms have to adjust their published prices. The higher the inflation rate, the more often prices need adjusting. Updating menus, catalogs, and websites takes time and therefore costs money. Problems of this sort are called the menu costs of inflation.
Unexpected Inflation
If the rate of inflation from one year to the next is higher or lower than economists and consumers expected, then unexpected inflation is said to have occurred. Unlike expected inflation, unexpected inflation can have serious consequences for consumers and firms, well beyond the inconvenience of expected inflation. The major effect of unexpected inflation is a redistribution of wealth either from lenders to borrowers, or vice versa.
Remember that inflation reduces the real value of a dollar (the dollar will not buy as much as it once did). Thus, if a bank lends money to a consumer to purchase a home, and unexpected inflation is high, the money paid back to the bank by the consumer will have less purchasing power or real value than the bank was counting on, because of the effects of inflation. The bank will be unhappy, but the borrower will be happy because the size of their debt, in inflation-adjusted terms, is shrinking faster than planned.
On the other hand, if a bank lends money and inflation turns out to be lower than expected, then the shoe is on the other foot. The lender gains wealth, since the money paid back at interest is of more value than the borrower expected. The borrower, meanwhile, is unhappy because their debt is greater, after adjustment for inflation, than they had been anticipating.
In volatile circumstances, when inflation seems to be moving unexpectedly, neither lenders nor borrowers will want to risk the chance of hurting themselves financially, and this hesitancy to enter the market will hurt the entire economy. (For a little more on this issue, see also the discussion of the Fisher equation in the chapter on the Market for Money.)
