All prices of goods and services in the economy are expressed in currency terms, whether that currency might be the U.S dollar, the British pound, the Euro, or the Zimbabwe dollar. Right now, most economies are experiencing inflation. Did you know that inflation, whether it is high or low, gives rise to the unit of account costs?
Unit of account costs are costs that we face when our economy experiences inflation. Unit of account costs result from money losing its credibility as a unit of account measurement in the economy.
Why don't you read on and find out all there is to know about the unit of account costs and how they impact you?
Unit of Account Costs Definition
To understand the unit of account costs definition, let's consider how contemporary money works. Today, we are used to money operating as a unit of account. This means that money serves as objective mathematical units and is divisible, fungible, and countable. The main function of money is to serve as a unit of account, which is a standard numerical monetary unit of measurement of the price of goods and services in the economy.
In inflationary periods money loses value which leads to the unit-of-account cost of inflation.
The unit-of-account costs of inflation are costs associated with money becoming a less reliable unit of measurement.
Evolution of Money
Long ago, money typically consisted of coins made of precious metals like gold and silver. Coins and ingots (small bars) of gold and silver could have different sizes and weights and sometimes be broken into slivers for smaller purchases and change. This could lead to discrepancies over accurate size and weight.
The creation of modern paper money helped reduce transaction costs by making money more of a reliable unit of account. Unlike coins or ingots that could have non-uniform sizes and weights, paper currency was objective because it had a stated numerical value. These numbers could be added and divided much more easily than the weights of gold coins.
Different bills could be added together quickly and efficiently to make a purchase, with no haggling over the correct weight measurement. The change was more accessible since it simply involved returning smaller-denomination bills to the customer rather than cutting pieces off the original invoice.
However, due to inflation, paper money can lose its value over time which comes with costs. One of the main effects of the unit-of-account cost is that it makes economic decisions less efficient in the economy by giving rise to uncertainty in the function of money as a unit of account.
Unit of Account Costs of Inflation
Unit of account costs of inflation refers to the costs that are associated with money becoming a less reliable unit of measurement.
One weakness of transitioning from gold and silver coins to paper money was a greater tendency to experience inflation.
Inflation is defined as a rise in the general level of prices.
Paper currency inflates more quickly than gold coinage because paper money is far easier to produce. Initially, it was also much easier to counterfeit or make illegally. Bank notes and government currency could be overprinted and cause inflation through sellers charging higher prices after realizing there was more money in circulation.
- At first, governments tried to limit the overprinting of paper currency by maintaining a gold standard. The gold standard meant that each paper dollar had to be backed by a specific amount of gold, which could be held in a bank vault.
- After the end of the gold standard, governments tried to limit inflation through modern monetary policy, which meant controlling the money supply. Today, this means setting interest rates and regulating the lending practices of commercial banks.
Although there are attempts to limit inflation, it still exists, and it is present. Inflation directly impacts the unit-of-account function of money as basically all the measurements expressed in currency terms lose real value.
If you consider an inflation rate of 20% and you have a $100 bill, that bill loses real value, which means that you can buy about 20% less worth of goods and services with the same $100 bill. However, the unit of measurement in the $100 bill does not change, $100 remains the same.
Unit-of-account costs have a peculiar impact on the tax system.
Think of an individual who invests $10,000 to buy a piece of land. The inflation rate is 10%. That means that the price of all goods and services increases by 10% (including the piece of land the individual has invested in). That is to say that the land's price became $11,000. The guy who bought the land decided to sell, making a $1,000 profit. The government will tax the guy on capital gains. But did this guy really make a $1,000 profit from selling the land?
The answer is no. In real terms, the price of land has remained the same due to the 10% inflation rate the economy has experienced. The $11,000 could get you the same goods and services as the $10,000 the year prior to the economy experiencing inflation. Hence, the individual makes no real gain on the sale but incurs a loss because of taxation.
One of the main effects of the unit-of-account cost of inflation is the loss of real purchasing power by individuals.
Fig 1. - Money losing value as a result of inflation
Figure 1 above shows the real value of 10 euros after the economy experienced a 10% increase in inflation. Although the unit of measurement is 10, the real purchasing power of the 10 euro bill has dropped to 9, meaning that with ten euros, one could only buy actually 9 euros worth of goods, although you are paying 10.
Example of Unit of Account Cost
Examples of unit of account costs relate to the loss in real purchasing power of individuals.
As an example of a unit of account cost, let's consider George, who borrows money from his best friend, Tim. George borrows $100,000 from Tim to open up a business. The agreement is made such that George will return the money the following year and pay 5% interest.
However, the same year there was a supply shock in the economy, which caused the price of goods and services to increase by 20%. That means that if the $100,000 were to keep up with inflation, meaning that Tim maintains his purchasing power upon the return of money, the $100,000 should now be worth $120,000. However, as Tim and George agreed that George would be giving back $105,000, Tim lost \(\$120,000-\$105,000=\$15,000\) in purchasing power due to the unit of account cost of inflation. This example shows that inflation is good for debtors and bad for creditors because while debtors pay their debt back with money that is worth less, creditors receive money back that is worth less.
Unit of Account Function of Money
The unit of account function of money is to provide objective, measurable value to different goods and services. This makes it easy to complete economic transactions, such as buying and selling.
A unit of account refers to a measurement that can be used to value goods and services, make calculations and record debt.
The unit of account function of money refers to the use of money as the base of comparison individuals use to value goods and services, make calculations and record debt.
Before money, trade occurred through a time-consuming process where goods and services were traded for other goods and services. This is known as a barter system and is very inefficient. Without objective prices or measurements, the number of goods that could be exchanged for other goods differed daily. This could lead to hostility and a breakdown of trade.
Fig 2. - US dollar
Figure 2 above shows the US dollar, which is used as a unit of account in the United States and worldwide. A major part of international trade between countries is conducted in US dollars.
We have an entire explanation explaining all the Types of Money in detail. Check it out!
Having objective units of account also allows buyers and sellers to easily determine if a trade is worth it. Buyers know how much money they have in total and can compare the price of the desired good against this total. Conversely, sellers can set a sale price that covers their production costs.
Without objective units of money, both of these would be difficult. Money that can operate as a unit of account allows for quick, rational economic decisions and for money to be spent on the most profitable endeavor. Ultimately, this leads to greater economic growth.
Menu Costs vs Unit of Account Costs
The main difference between the menu costs vs. unit of account costs is that menu cost refers to the costs businesses face when changing the nominal prices of their products due to inflation. Unit of account costs are costs that are associated with the decline in the reliability of using money as a unit of account.
Because today's money serves as an objective unit of account, prices can be adjusted periodically to deal with inflation.
The costs incurred by having to adjust prices are known as menu costs.
In previous decades, when menus at restaurants were physically printed, these costs could be considerable. If there was high inflation, menus might need to be printed every few months so that customers would pay higher prices. Today, using electronic boards and websites for restaurant menus removes some of these costs.
Menu costs can also occur in renegotiating contracts due to inflation. While the physical printing of menus may no longer be common, negotiating business contracts remains an ongoing cost.
When inflation is high, contracts may need to be negotiated every quarter (three-month period) rather than just once a year. This can mean businesses pay higher legal fees.
We have an entire explanation covering Menu Costs. Don't forget to have a look at it!
Shoe Leather vs Unit of Account Costs
The main difference between shoe leather vs. unit of account costs is that shoe-leather costs refer to the increased costs of transactions as a result of inflation. On the other hand, the unit of account costs refers to the costs arising because money becomes a less reliable unit of account.
Shoe-leather cost is the increased cost in transactions due to inflation.
Customers shop around for deals to avoid paying higher prices due to inflation. The costs incurred by shopping around are known as shoe leather costs, as in previous generations, people had to walk from store to store physically. Even in the digital era, where consumers shop for deals online rather than walking from store to store, the time costs of finding deals are equivalent to shoe leather costs.
For example, an individual who gets paid $30 an hour and spends 4 hours looking around the web or going around stores to limit the effect of inflation has a shoe leather cost of $120, as they could be spending that time working instead.
The expansion of shopping options due to online shopping may increase shoe leather costs in the modern era by driving many consumers to spend hours on different websites and scrutinizing scores of posted reviews.
When inflation is high, consumers may feel driven to spend more time than usual searching for the optimal deal on any purchase.
We have covered Shoe Leather Costs in detail in our other article. Don't miss it!!
Unit of Account Costs - Key takeaways
- The unit-of-account costs of inflation are costs associated with money becoming a less reliable unit of measurement.
- A unit of account refers to a measurement that can be used to value goods and services, make calculations and record debt.
- The unit of account function of money refers to the use of money as the base of comparison individuals use to value goods and services, make calculations and record debt.
- Shoe-leather cost is the increased cost in transactions due to inflation.
- The costs incurred by having to adjust prices due to inflation are known as menu costs.