2. 1 The Costs of Inflation

3. 2 Wages and prices rise and fall together. Inflation does not erode real wages.

4. 3 Inflation and Real Wages Increase in wages = Increase in productivity + increase in prices Example: Increase in productivity = 3% Inflation = 2% Increase in wages = 2+3 = 5% Only 3% is “earned” by your increase in productivity. The remaining 2% is simply to keep your real wage from falling due to rising prices. But you believe that you “earned” 5% and inflation “robbed” you of 2%”

5. 4 Inflation is blamed for changes in relative prices You are hurt if prices of the items you sell increase less than the prices of the items you buy Price of software increase 2% but gasoline prices rise 5% Inflation: Increase in “average” prices: some prices rise, some fall, some remain the same: some are hurt, some are helped… Price of clothing increase 3% but wages paid to your workers rise 2%

6. 5 Redistribution of Income People on fixed incomes (pensions, welfare) lose purchasing power Individuals whose incomes grow slower than inflation (minimum wage) lose purchasing power. Arbitrary redistribution of income

8. 7 The Cost of Unanticipated Inflation Unanticipated inflation: when your guess about inflation turns out to be wrong.

9. 8 Lenders Protect from inflation by charging interest If I borrow $100 today at 10% interest I must return $100 + 100 (0.1) = 100 + 10 = $110. If inflation is zero, the lender makes a 10% real return.

10. 9 Inflation Hurts Lenders If there is inflation over the year, when I return the $100 a year from now, that money is worth less. In real terms, I returned LESS money than I borrowed.

11. 10 The Real Interest Rate If inflation is 5%, money loses 5% of its value over the year With a 5% inflation, the lender no longer makes 10% real interest on the loan but 10% - 5% = 5%

12. 11 The Real Interest Rate Real Interest Rate = Nominal Interest Rate – Inflation Rate.

13. 12 Guess Inflation = 5% Charge 15% interest If you guess right, and inflation is 5%, you will make a 10% real return. Nominal (15%) – Inflation (5%) = Real (10%) If you guess wrong and inflation is 9%, you will make a 6% return Nominal (15%) – Inflation (9%) = Real (6%) If you are very wrong and inflation is 20%, you will make a negative return (you are giving money away!) Nominal (15%) – Inflation (20%) = Real (-5%)

14. 13 Anticipating Inflation If inflation could be fully anticipated, the lender would include inflation in the nominal rate. When inflation is “volatile” -changes frequently and unpredictably- it is very difficult to guess When inflation is “stable” it is easier to guess. High inflation is more likely to be volatile… Low inflation is more likely to be stable…

15. YearIndexInflation 1996100.520.2 1997101.050.5 1998101.980.9 1999100.79-1.2 200099.85-0.9 200198.78-1.1 2002124.3325.9 2003141.0513.4 2004147.284.4 2005161.489.6

16. YearIndex Inflation 1996 156.9 1997 160.5 2.3 1998 163 1.6 1999 166.6 2.2 2000 172.2 3.4 2001 177.1 2.8 2002 179.9 1.6 2003 184 2.3 2004 188.9 2.7 2005 195.3 3.4

17. 16 Colombia

18. 17 Ecuador

19. 18 Venezuela

20. 19 Inflation: The most unfair tax… Capital gains and interest income are taxed. Suppose you lend (or buy any interest bearing asset for) $100 for a 15% return. Suppose that the tax on your interest income is 30%. In this transaction you make $15 in interest The government takes 30% of that = $4.50.

21. 20 The Inflation Tax With zero inflation, you would make 15% ($15) in interest and pay 30% ($4,50) tax. With a 5% inflation, in real terms you make only 10% ($10) BUT YOU STILL PAY $4,50 in tax! The tax is taken from the nominal return not from the real return Paying $4,50 out of a $10 return is equivalent to a tax of 45% instead of the intended 30%.

22. Who suffers from inflation? People on fixed incomes & workers (if wages not fully adjusted by inflation) The poor (government transfers to the poor are not indexed). Wages and incomes can be easily adjusted for inflation… Lenders Lenders could factor inflation and taxes into the interest rate Individuals whose incomes come mainly from capital gains and interest income… The government could index tax system (charge tax on real returns)

23. 22 Who Gains from Inflation? Borrowers! Because they pay back less than they borrowed… Sellers, if the prices they receive rise faster than the prices they pay. Government because tax revenues increase as inflation pushes taxpayers into higher income brackets.

24. 23 Inflation does no special harm to the poor During inflationary periods the prices paid by the poor rise neither faster nor slower than the prices paid by the rest of us. Inflation does not raise the incomes of the rich relative to those of the poor. The opposite is true: Real incomes at the bottom rise relative to those at the top Making income distribution slightly more equal. Only identifiable loss: government’s failure to index transfers to the poor and tax real instead of nominal returns.

25. 24 How do we Fight Inflation? Joblessness. Slow down Aggregate Demand for goods and services. Policy tool of choice: interest rate hikes by the Federal Reserve Bank.