Inflation is tearing through the country! The currency is rapidly losing its value, causing people to panic left and right. This panic will make people act in rational and irrational ways. However, one thing that people will want to do once the currency starts to rapidly lose value is to go to the bank. Why the bank? What's the purpose of going to the bank if the currency is losing value day by day? Believe it or not, there IS something that people can do in a time like this. To find out about shoe leather costs, continue reading!
Shoe Leather Costs Meaning
Let's go over the meaning of shoe leather costs. Before we talk about shoe leather costs, we must review inflation.
Inflation is the general increase in the price level.
To better understand inflation, let's look at a brief example.
Let's say that the United States is seeing increased prices of all goods. However, the value of the dollar remains the same. If the value of the dollar stays the same, but the prices increases, then the purchasing power of the dollar is decreasing.
Now that we understand what inflation does to the purchasing power of the dollar, we can go over shoe leather costs.
Shoe leather costs refer to the costs that people incur to minimize their cash holdings during times of high inflation.
This can be the effort that people expend to get rid of the current currency for a stable foreign currency or asset. People take these actions because rapid inflation lowers the currency's purchasing power. For further clarification, let's look at some examples of shoe leather costs.
To learn more about inflation, check out our explanations:
- Inflation
- Inflation Tax
- Hyperinflation
Shoe Leather Costs Examples
Let's now take a more in-depth look at a shoe leather cost example. Let's say that the United States is undergoing record-level hyperinflation. Citizens know that it is not wise to hold on to money right now since the value of the dollar is dramatically falling. What will Americans do given that hyperinflation is making their money nearly worthless? Americans will rush to the bank to convert their dollars into some other asset that is appreciating, or at the very least stable. It will usually be some type of foreign currency that is not undergoing hyperinflation.
The effort that Americans will go through to make this exchange at the bank is the shoe leather cost. During hyperinflation, there will be a glut of people attempting to convert the failing currency for another one that is more stable. Trying to accomplish this while everyone else is panicking and banks are overrun with people will make this process even more difficult. Banks will be overwhelmed with the number of people needing their service, and some people may not be able to exchange their currency due to the high demand. It is overall an unpleasant situation to be in for all parties.
Germany in the 1920s
A famous example of shoe leather costs involves Germany in the post-World War I era. In the 1920s, Germany was experiencing very high levels of inflation — hyperinflation. From 1922 to 1923, the price level increased around 100 times! During this time, German workers were paid multiple times a day; however, it did not mean much since their paychecks could hardly pay for goods and services. Germans would rush to the banks to exchange their failing currency with foreign currency instead. The banks were rushed so much that the number of Germans that worked in banks from 1913 to 1923 rose from 100,000 to 300,000!1
Shoe Leather Costs Economics
What are the economics behind shoe leather costs? Shoe leather costs will not happen without inflation; therefore, there needs to be a catalyst for inflation to cause shoe leather costs. Regardless of the cause of inflation — whether it's cost-push or demand-pull — there will be an output gap in the economy. As we know, output gaps in the economy mean that the economy is not in equilibrium. We can use this information to look at further implications regarding shoe-leather costs and the economy.
For shoe leather costs to occur, the economy must be operating below or above equilibrium. If there is no inflation, then there are no shoe leather costs. Therefore, we can determine that shoe leather costs are a byproduct of an economy that is not in equilibrium.
Fig. 1 - U.S. Consumer Price Index for May. Source: U.S. Bureau of Labor Statistics.2
The chart above shows us the U.S. consumer price index for May. Here, we can see that the CPI is stable until 2020. The CPI shoots up from around 2% to 6%. With rising inflation, there may be an increase in shoe leather costs depending on how each person views the severity of inflation. Those who view inflation as a huge problem will be more incentivized to exchange their domestic currency for a foreign one.
Shoe Leather Costs Inflation
Shoe leather costs are one of the main costs of inflation. Inflation causes the purchasing power of the dollar to decrease; thus, causing people to rush to the bank to convert their dollars to another asset. The effort needed to convert the dollars to another asset IS shoe leather costs. But how much inflation is needed to see an increase in shoe-leather costs?
Generally, substantial inflation is required for shoe leather costs to be prominent in an economy. Inflation has to be high enough to warrant panic in the public and motivate people to convert their domestic currency to a foreign one. Most people would not do this to their entire life savings unless inflation was very high! Inflation would need to be around 100% or more to elicit this response.
However, what might shoe leather costs look like if there is deflation? Will we see the same effect with inflation? Will we see an adverse effect? Let's look deeper into this phenomenon!
What about Deflation?
What about deflation then? What does it mean for the purchasing power of the dollar?
Deflation is the general decrease in the price level.
While inflation causes the purchasing power of the dollar to decrease, deflation causes the purchasing power of the dollar to increase.
For example, let's say that the United States is experiencing a 50% decrease in the price of all goods while the value of the dollar does not change. If $1 was able to buy you a $1 candy bar before, $1 will now buy you two ¢50 candy bars! Therefore, the purchasing power of the dollar increased with inflation.
If deflation causes the purchasing power to increase, will people want to go to the bank to convert the dollar to another asset? No, they would not. Recall why people will rush to the bank during inflation — to convert their depreciating dollar into an appreciating asset. If the value of the dollar is increasing during inflation, then there's no reason for people to rush to the bank and convert their dollar into another asset. Instead, people will be incentivized to save their money so that the value of their currency keeps increasing!
Shoe Leather Costs vs Menu Costs
Like shoe leather costs, menu costs are another costs that inflation imposes on the economy.
Menu costs are the costs for businesses to change their listed prices.
Businesses have to bear menu costs when they have to change their listed prices more frequently to catch up with high inflation.
Let's take a brief look at both menu costs and shoe leather costs for further clarification. Imagine that inflation is high in the country! The value of the currency is decreasing rapidly, and people need to act fast. People are rushing to the bank to exchange their money for other assets that aren't rapidly declining in value. People are spending time and effort in doing this and incurring shoe leather costs. On the other hand, businesses are having to increase their listed prices all across the board to keep up with the increasing costs of their inputs of production. In doing so, businesses are incurring menu costs.
Let's now look at a more specific example of menu costs.
Mike owns a pizza shop, "Mike's Pizzas," where he sells an entire large pizza for $5! This is such a great deal that the whole city raves about it. However, inflation strikes the United States, and Mike is faced with a dilemma: raise the price of his signature pizzas, or keep the price the same. Ultimately, Mike will decide to raise the price from $5 to $10 to keep up with inflation and maintain his profits. As a result, Mike will have to get new signs with the new prices, print out new menus, and update any systems or software. The time, effort, and material resources spent on these activities are the menu costs for Mike.
To learn more, check our explanation: Menu Costs.
Shoe Leather Costs - Key takeaways
- Shoe leather costs are the costs that people incur to minimize their cash holdings during times of high inflation.
- Inflation is the general increase in the price level.
- Shoe leather costs are most prominent during times of hyperinflation.
References
- Michael R. Pakko, Looking at Shoe Leather Costs of Inflation, https://www.andrew.cmu.edu/course/88-301/data_of_macro/shoe_leather.html
- U.S. Bureau of Labor Statistics, CPI for All Urban Consumers, https://data.bls.gov/timeseries/CUUR0000SA0L1E
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