Inflation Chapter #8

The Costs of Inflation Costs of extremely high inflation obvious ($ no longer medium of exchange) Costs of E(inflation) not obvious but public’s distaste makes it policy issue Perfectly anticipated inflation: If economy is experiencing 5% inflation & anticipated inflation is also 5%, all contracts will build in expected 5% inflation Nominal interest rates account for the inflation Long term labor contracts account for the inflation Tax brackets are typically adjusted to account for the inflation  Inflation has no real costs, except for two qualifications: Costs of holding currency ↑ with inflation & demand for currency decreases Menu costs of inflation Imperfectly anticipated inflation: better description of real world economies Most contracts in nominal terms. W/ unexpectedly ↑/↓ inflation debtors repay loans in cheaper/more expensive $. Some market exchanges skipped for inflation risk. Distributional cost of unexpected inflation (debtors vs. creditors) for all fixed assets Money, bonds, savings accounts, insurance contracts, some pensions Realized real interest rates are lower than nominal interest rates if inflation ↑

Inflation and Indexation W/ high & uncertain inflation, long-term nominal borrowing is impossible: lenders too uncertain about real value of repayments they will receive Solution is indexed debt: either interest or principle or both adjust for inflation Interest typically equals stated real rate plus actual inflation  risk reducing Some labor contracts include cost of living adjustment (COLA) Suppose real prices of material ↑ & firms pass cost ↑ on as ↑ output prices W/ COLA wages also ↑, leading to further CGS, price & wage ↑ Indexation feeds an inflation spiral Differentiate supply & demand shocks to understand COLA consequences W/ demand shock there is “pure” inflation disturbance & firms can pay the same real wages w/o being affected by indexation W/ supply shock real wages ↓ & full indexation prevents this from happening Wage indexation complicates econ adjustment to supply shocks Many call for broad scale indexation (including bonds & taxes) because: Inflation would be easier to live with Costs of unanticipated inflation would disappear Governments reluctant to index for three reasons: Indexing impedes adjust to shocks when changes in relative prices are needed Indexing adds another layer of calculation to most contracts Indexation weakens political will to fight inflation make the economy worse off