Inflation: An Overview AP Macro Mr. Warner

What you will learn in this Module: The economic costs of inflation The difference between real and nominal values of income, wages, and interest rates, and how to “win” the inflation game

The Level of Prices Doesn’t Matter... Misconception – it’s all relative Only look at REAL wage, REAL income How would you spend your 10$? NOTE: Economists often toss around little phrases like “there’s no such thing as a free lunch”. Another phrase that is pertinent to this material is “only relative prices matter”. Create an example to illustrate this point.   Example: A student in the class has income of $20 per week to spend on gasoline ($2 per gallon) or venti  mochachino café lattes (at $4 per cup). We can see her purchasing possibilities in a table below. The most gas she could buy: The most lattes she could buy: To buy one more latte, she must give up: 10 gallons of gas 5 cups 2 gallons of gas One gallon of gas uses up 10% of her income. One cup of mochachino uses up 20% of her income. What would happen if her income doubled and so did the price of gasoline and the price of a café latte? Absolutely nothing! The prices of gas and café lattes, relative to her income is unchanged. The price of a cup of latte, relative to the price of a gallon of gas is unchanged. Nothing REAL has changed. Drinks Snacks 2$ 4$

...But the Rate of Change of Prices Does Inflation rate = Shoe-Leather Costs: increased transaction costs, wasted time, forced to carry more Hyperinflation: people lose trust in the currency, so hope to spend it as quickly as possible – feedback loop Menu Costs: wasting time changing prices Unit-of-Account Costs: when inflation isn’t accounted for in ongoing costs Price level in year 2 - Price level in year 1 Price level in year 1 X 100 Note: refer back to the previous example.   But what if the price of gas and café lattes doubles, while the student’s income stays the same? The most gas she could buy: The most lattes she could buy: To buy one more latte, she must give up: 5 gallons of gas 2.5 cups 2 gallons of gas One gallon of gas uses up 20% of her income. One cup of mochachino uses up 40% of her income. The price of a cup of latte, relative to the price of a gallon of gas is unchanged. But! Relative to her income, these items are now twice as costly. Obviously, this price inflation has radically decreased her purchasing power because her income did not rise to keep pace. In a very REAL sense, she is worse off. What would she do? What would the sellers of gas and café lattes do? Inflation creates costs for both groups of people. 1. Shoe leather costs We might expect the student in the example above to be pretty upset about the doubling prices of two goods she really enjoys consuming. What would she do? She might spend a lot of time looking for less expensive substitutes. She might drive around town looking for a coffee shop with prices that haven’t doubled. She might decide that she needs to get her $20 of income out of her wallet (where it is quickly become worthless) and into something else that might hold value better. All of this extra time and effort comes at a cost to the consumer. Shoe leather cost is an allusion to the wear and tear caused by the extra running around that takes place when people are trying to avoid holding money. Or increased costs of transactions caused by inflation. 2. Menu Costs What would the sellers of gas and café lattes need to do? Change their menus or signs. This might not be very expensive for the gas station, they would just need to have a paid employee go outside and change the sign. But a restaurant or coffee shop might need to literally print new menus and this is pretty costly. And what if this price inflation persists? Maybe prices are rising 10% every few months and menus neeed to be constantly changed as a result. These are costs incurred by the sellers just to update the posted prices. 3. Unit-of-Account Costs The costs arising from the way inflation makes money a less reliable unit of measurement. These costs can emerge from the way in which we tax certain assets. Suppose you owned a house that was worth $100,000 and your state levied a property tax of 1% on that house. Each year you expected to pay $1000 in property taxes. Over the course of a short period of time, maybe two years, real estate prices go way, WAY up. Now your house, on paper, is worth $200,000 but it’s the very same house. It’s not a better house. Your state reassesses property taxes and now claims that you owe $2000 every year! Assuming your income didn’t double as your house was doubling in value, you are worse off because the property tax system didn’t take into account that it was inflation that caused your house to increase in value.

Winners and Losers from Inflation If you can trust your friend 100%, does it make good economic sense to lend her $100 if she agrees to pay you back with interest, say 5% or 8%? Nominal interest rate v. real interest rate: nominal takes into account expected inflation, so the nominal interest rate = real interest rate + expected inflation Note: Stress to students that inflation can often just redistribute money from one person to another. A good example of this can be seen when we look at borrowers and lenders.   Suppose you lend a buddy $100 and he promises you pay you back in a year. There are two reasons why it makes sense to charge him interest. 1. By providing this service to your friend, you won’t have that $100 over the next year to buy things that you enjoy. Your service, and delayed consumption, should entitle you to compensation. 2. When he pays you back, inflation will have eroded the purchasing power of the original $100. Knowing this, you should be entitled to enough interest so that inflation doesn’t hurt your purchasing power. So the interest rate should have two parts: the part to compensate you for the service you are providing, and the part that offsets the inflation that is expected to occur. Economists call the sum of these two parts the nominal interest rate: Nominal interest rate = real interest rate + expected inflation Suppose you and your friend agree that inflation next year will be 5% and you agree that your lending services are worth another 3%. You charge your friend: 8% = 3% + 5% After a year’s time, three scenarios could have happened. Scenario 1: you expected 5% inflation and you experienced exactly 5% inflation. The purchasing power of the $100 you lent was unchanged when your friend paid you back exactly enough to compensate for the inflation. Scenario 2: you expected 5% inflation and you experienced only 1% inflation. Your purchasing power has actually increased because your friend paid you back more than enough to compensate for the inflation. Note: When actual inflation is below expected inflation, the lender (in this case you) gains and the borrower loses. Scenario 3: you expected 5% inflation and you experienced 8% inflation. Your purchasing power has actually decreased because your friend paid you back less than enough to compensate for the inflation. Note: When actual inflation is above expected inflation, the lender (in this case you) loses and the borrower gains.

Winners and Losers from Inflation Note: Stress to students that inflation can often just redistribute money from one person to another. A good example of this can be seen when we look at borrowers and lenders.   Suppose you lend a buddy $100 and he promises you pay you back in a year. There are two reasons why it makes sense to charge him interest. 1. By providing this service to your friend, you won’t have that $100 over the next year to buy things that you enjoy. Your service, and delayed consumption, should entitle you to compensation. 2. When he pays you back, inflation will have eroded the purchasing power of the original $100. Knowing this, you should be entitled to enough interest so that inflation doesn’t hurt your purchasing power. So the interest rate should have two parts: the part to compensate you for the service you are providing, and the part that offsets the inflation that is expected to occur. Economists call the sum of these two parts the nominal interest rate: Nominal interest rate = real interest rate + expected inflation Suppose you and your friend agree that inflation next year will be 5% and you agree that your lending services are worth another 3%. You charge your friend: 8% = 3% + 5% After a year’s time, three scenarios could have happened. Scenario 1: you expected 5% inflation and you experienced exactly 5% inflation. The purchasing power of the $100 you lent was unchanged when your friend paid you back exactly enough to compensate for the inflation. Scenario 2: you expected 5% inflation and you experienced only 1% inflation. Your purchasing power has actually increased because your friend paid you back more than enough to compensate for the inflation. Note: When actual inflation is below expected inflation, the lender (in this case you) gains and the borrower loses. Scenario 3: you expected 5% inflation and you experienced 8% inflation. Your purchasing power has actually decreased because your friend paid you back less than enough to compensate for the inflation. Note: When actual inflation is above expected inflation, the lender (in this case you) loses and the borrower gains. Let’s go back to the loan between two people, say Mr. Murphy and Mr. Freedman. Mr. Murphy knows about inflation, so when he loans out money he wants 5% interest, and expects 3% inflation, so he charges 8% total interest. Who wins if: A) Inflation = 1% B) Inflation = 3% C) Inflation = 5%

Winners and Losers from Inflation Who are the winners and losers if there’s inflation? Note: Stress to students that inflation can often just redistribute money from one person to another. A good example of this can be seen when we look at borrowers and lenders.   Suppose you lend a buddy $100 and he promises you pay you back in a year. There are two reasons why it makes sense to charge him interest. 1. By providing this service to your friend, you won’t have that $100 over the next year to buy things that you enjoy. Your service, and delayed consumption, should entitle you to compensation. 2. When he pays you back, inflation will have eroded the purchasing power of the original $100. Knowing this, you should be entitled to enough interest so that inflation doesn’t hurt your purchasing power. So the interest rate should have two parts: the part to compensate you for the service you are providing, and the part that offsets the inflation that is expected to occur. Economists call the sum of these two parts the nominal interest rate: Nominal interest rate = real interest rate + expected inflation Suppose you and your friend agree that inflation next year will be 5% and you agree that your lending services are worth another 3%. You charge your friend: 8% = 3% + 5% After a year’s time, three scenarios could have happened. Scenario 1: you expected 5% inflation and you experienced exactly 5% inflation. The purchasing power of the $100 you lent was unchanged when your friend paid you back exactly enough to compensate for the inflation. Scenario 2: you expected 5% inflation and you experienced only 1% inflation. Your purchasing power has actually increased because your friend paid you back more than enough to compensate for the inflation. Note: When actual inflation is below expected inflation, the lender (in this case you) gains and the borrower loses. Scenario 3: you expected 5% inflation and you experienced 8% inflation. Your purchasing power has actually decreased because your friend paid you back less than enough to compensate for the inflation. Note: When actual inflation is above expected inflation, the lender (in this case you) loses and the borrower gains. Bond holders and other lenders Owners of physical capital Retired People Mortgage holders, people with debt Savers Consumers