Inflation
MODULE 14
What you will learn in this
Module:
The economic costs of inflation
How inflation creates winners and losers
Why policy makers try to maintain a stable rate of
inflation
The difference between real and nominal values
of income, wages, and interest rates
The problems of deflation and disinflation
The Costs of Inflation:
A Fall in Purchasing Power?
INFLATION DOES NOT
IN ITSELF REDUCE
PEOPLE’S REAL
PURCHASING POWER .
The Level of Prices Doesn’t Matter…
As price levels rise so do nominal
wage rates
This means that your real wage
(what your income buys you) hasn’t
changed.
…But the rate of inflation does
Price level changes
versus
changes in the
inflation rate
Even though rises in the price level are met by
increases in wages in the long term, short- run
increases in the rate of inflation have costs
The Costs of Inflation
Shoe leather costs
Menu costs
Unit of Account Costs
Shoeleather Costs
Shoeleather costs are the resources wasted when
inflation encourages people to reduce their
money holdings.
Inflation reduces the real value of money, so
people have an incentive to minimize their cash
holdings.
In post WWI Germany store owners employed
runners to take cash to the bank several times a
day to convert it into something that would hold
value, such as a foreign currency.
Menu Costs
Menu costs are the costs of adjusting
prices.
During inflationary times, it is necessary
to update price lists and other posted
prices.
In Argentina store owners locked their
doors in the early afternoon to make
price changes.
Unit of Account Costs
Inflation
causes our money to no longer be useful as a Unit
of Account (used to explain relative value of goods, services
and financial assets).
This is because inflation distorts relative prices.
Inflationexaggerates the size of capital gains and increases
the tax burden on this type of income.
Anasset that earns 10% over its original price, during a
period with a 10% inflation rate breaks even but would be
taxed as a 10% increase in profit
Winners and Losers from Inflation
Inflation affects individuals differently depending on
their role in a financial transaction and whether or not
the inflation was expected.
To understand this we need to understand the
difference between Real and Nominal Interest Rates
• Interest rates are the percentage of a loan that must be
paid in addition to the loan amount.
• Interest rates represent a percentage of the current
value of borrowed money (the real rate) plus an
additional percentage to cover inflationary
expectations.
Real and Nominal Interest Rates
The nominal interest rate is the interest rate not
corrected for inflation.
It is the interest rate that a bank states.
Nominal interest rate = (Real rate + expected
inflation rate)
The real interest rate is the nominal interest rate
that is corrected for actual inflation.
Real interest rate = (Nominal interest rate –
Inflation rate)
Real and Nominal Interest Rates
You borrowed $1,000 for one year.
Nominal interest rate was 15%. (The bank needed 10% to cover
their costs and 5% to cover expected inflation)
During the year inflation was 10%.
Real interest rate = Nominal interest rate – Inflation
= 15% - 10% = 5%
The winner in this situation was the borrower who ultimately pays
back money that is worth less than when it was borrowed.
The bank is the loser; it is being repaid money that is worth less
than when it was borrowed.
Real and Nominal Interest Rates
Interest Rates
(percent per
year)
15
Nominal
interest rate
10
Real interest rate
-5
1965 1970 1975 1980 1985 1990 1995 1998
Who’s Hurt? Who’s Helped?
By Unanticipated Inflation
You’re hurt if you are a You’re helped if you are a
Creditor – the money Borrower- the money
you loan out is worth you are repaying is worth
less when its paid back less
Saver – inflation rates Flexible income earner-
are normally higher than if your income is tied to
interest rates profits you will earn more
Fixed income receiver- a If your income is adjusted
constant income will buy for inflation you will earn
more (COLA)
less.
Payer of fixed amounts
Inflation is easy; Disinflation is hard
Disinflation – bringing the inflation rate
down can cause high levels of
unemployment.
When the inflation rate reached 14% in the
late ‘70s early ‘80s the Federal Reserve
adopted disinflationary measures.
The disinflation of the 1980s caused a
severe recession with unemployment rates
of 10.8%
The Cost of Disinflation