RElATIVE PRICE VARIABIUTY AND THE MISALLOCATION OF RESOURCES

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RELATIVE-PRICE VARIABILITY AND THE MISAPPLICATION OF RESOURCES

Suppose that the Eatabit Eatery prints a new menu with new prices every January and then  unchanged for the rest of the year. If there is no inflation, Eatabit’s relative prices-the prices of its meals compared to other prices in the economy-would be constant over the course of the year.

By contrast, if the inflation rate is 12 percent per year, Eatabit’s relative prices will automatically fall by I percent each month. Th’e restaurant’s relative prices will be high in-die early months of the year, just after it has printed a new menu, and low in the later months. And the higher the inflation rate, the greater is this automatic variability. Thus, because prices change only once in :J while. inflation causes relative prices to vary
than they otherwise would.

Why does this matter? The reason is that market economies rely on relative prices to allocate scarce resources. Consumers decide what to buy by comparing the quality and prices of various goods and services. Through these decisions, they determine how the scarce factors of production are allocated among industries and firms. When inflation distorts relative prices, consumer decisions are distorted, and markets are less able to allocate resources to their best use.

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RElATIVE PRICE VARIABIUTY AND THE MISALLOCATION OF RESOURCES