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. Inflation exaggerates the size of capital gains and increases the tax burden on this type of income. An asset 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. 29

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) 30

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. 31

Real and Nominal Interest Rates (percent per year) 15 Nominal interest rate 10 5 Real interest rate -5 1965 1970 1975 1980 1985 1990 1995 1998 3

Who’s Hurt? Who’s Helped? By Unanticipated Inflation You’re hurt if you are a Creditor – the money you loan out is worth less when its paid back Saver – inflation rates are normally higher than interest rates Fixed income receiver- a constant income will buy less. You’re helped if you are a Borrower- the money you are repaying is worth less Flexible income earner- if your income is tied to profits you will earn more If your income is adjusted for inflation you will earn more (COLA) 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