Download perfectly anticipated inflation

8
INFLATION
FOCUS OF THE CHAPTER
• In this chapter we examine the costs of inflation.
• The cost of anticipated inflation is very small, at least at the moderate levels experienced in
industrial countries.
• The cost of unanticipated inflation can be quite large and is mainly distributional.
SECTION SUMMARIES
1.
The Costs of Inflation
Inflation is costly, or at least it can be. There is little cost associated with moderate levels of
perfectly anticipated inflationrates of inflation that are neither higher nor lower than anyone
expects. The cost of holding currency does rise slightly, with higher inflation the value of any
currency will erode more quickly. There is also a small cost associated with changing nominal
pricesreprinting prices on signs and menus, for example. This is called a menu cost, but with
low levels of inflation this cost is quite small.
Because contracts are negotiated with a level of anticipated inflation (  ) in mind, there are
much more substantial costs associated with imperfectly anticipated inflation. For example, a
banker making a loan with a 5 percent nominal interest rate expects to receive a real return of 5
e
percent –
 e (recall that the real interest rate is just the nominal interest ratethe rate of
inflation). The student who receives this loan expects to pay a real interest rate of 5 percent –  e .
If the rate of inflation is higher than either of them expects, the bank receives a lower real interest
rate than it had anticipated. The student pays a lower real interest rate than he or she had
expected to. In short, the student wins, the bank loses. The opposite will be true if the rate of
inflation is lower than expected; in this case, the real interest rate will be higher than anyone
anticipates. Creditors will benefit; debtors will be hurt.
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INFLATION
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The effects of unanticipated inflation are mostly distributional and operate on any asset fixed in
nominal terms. Obviously, it is an extremely important effect, since it can wipe out the purchasing power
of a lifetime’s saving that is supposed to finance retirement consumption.
2.
Inflation and Indexation: Inflation-Proofing the Economy
The major ways that unanticipated inflation redistributes income are through loans and wage
contracts. An alternative to negotiating contracts in nominal terms and worrying about the level
of future inflation is to index themtie their payoffs to the inflation rate. Wage contracts, for
example, might include automatic cost of living adjustments, or COLA provisions, which tie
nominal wages to the CPI. In countries where inflation rates are both high and uncertain, governments
typically issue indexed debt. A bond is indexed (to the price level) when either the interest or the principal
or both are adjusted for inflation.
Uncertainty about the outlook for inflation was one of the reasons a new financial instrument made its
appearance: the adjustable rate mortgage (ARM). This is a long-term loan with an interest rate that is
periodically (every year, for example) adjusted in line with prevailing short-term interest rates. To the
extent that nominal interest rates roughly reflect inflation trends, adjustable rate mortgages reduce the
effects of inflation on the long-term real costs of financing home purchases.
Of course, the CPI is not a perfect measure of inflation, and by tying wages and interest rates to
this measure we may just be trading one source of uncertainty for another. Indexation also
makes it more difficult for the economy to adjust to supply shocks, as it prevents real wages from
rising or falling without explicit negotiation. Indexation is used widely only in countries with
extremely high rates of inflation.
3.
Is a Little Inflation Good for the Economy?
Some economists argue that low rates of inflation can be beneficial, as they allow real wages to
adjust when necessary, without explicit negotiation. This is controversial, however, and a
significant departure from the traditional belief that zero inflation is always best.
KEY TERMS
adjustable rate mortgage (ARM)
cost-of-living adjustment (COLA)
imperfectly anticipated inflation
indexation
indexed debt
menu costs
perfectly anticipated inflation
GRAPH IT 8
We know that the real interest rate is equal to the nominal interest rate minus inflation. In this
Graph It, you will calculate the real interest rate for the years 1992-2012 and compare it to the
nominal interest rate.
Table 81
Year
Nominal
Interest
Rate
Inflation
Real
Interest
Rate
1992
3.4
3.0
0.4
1993
3.0
3.0
1994
4.3
2.6
1995
5.5
2.8
1996
5.0
3.0
1997
5.1
2.3
1998
4.8
1.6
1999
4.6
2.2
2000
5.8
3.4
2001
3.4
2.8
2002
1.6
1.6
2003
1.0
2.3
2004
1.4
2.7
2005
3.2
3.4
2006
4.7
3.2
2007
4.4
2.8
2008
1.4
3.8
2009
0.2
-0.3
2010
0.1
1.7
2011
0.1
3.1
2012
0.1
2.1
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INFLATION
CROSSWORD
ACROSS
3 one type of cost arising from perfectly anticipated inflation
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CHAPTER 8
5 these guys benefit when inflation is higher than anticipated
7 the type of wealth effect caused by unanticipated inflation
8 it is costly to hold money in this form when inflation is high
10 acronym for a long-term loan that is indexed to short-term interest rates
DOWN
1 ties nominal wages to price level and rate of inflation
2 indexation can make it hard for the economy to adjust to these
4 an inflation cost associated with visiting the bank often
6 lose when inflation is higher than anticipated
9 acronym associated with wage indexation
FILL-IN QUESTIONS
1.
An unforeseen increase in the rate of inflation benefits _________________, at the expense of
_________________.
2.
An expected increase in the rate of inflation hurts people who hold _________________.
3.
Inflation is the percent rate of change in _________________.
4.
When inflation is high and unpredictable governments may issue _________________.
5.
The cost of anticipated inflation is very
inflation can be quite
.
, while the cost of unanticipated
6.
- there are big winners and big losers.
The cost of unanticipated inflation is mainly
TRUE-FALSE QUESTIONS
T
F
1.
The effects of unanticipated inflation are mostly distributional.
T
F
2.
The costs of moderate (single digit) anticipated inflation are fairly trivial.
T
F
3.
The costs of high (triple and quadruple digit) anticipated inflation are quite
serious.
T
F
4.
High inflation makes holding currency less costly.
INFLATION
T
F
5.
Indexed debt must have an adjustable interest rate.
T
F
6.
Uncertainty about inflation in the U.S. has led to a recent rise in fixed rate
mortgages.
T
F
7.
Wage indexation can make it harder for the economy to adjust to shocks
requiring relative price changes.
T
F
8.
Firms can create real wage cuts by only partially adjusting wages for inflation.
MULTIPLE-CHOICE QUESTIONS
1. Anticipated inflation transfers wealth from
a. creditors to debtors
b. debtors to creditors
c. poor to rich
d. none of the above
2. Unanticipated inflation transfers wealth from
a. creditors to debtors
b. debtors to creditors
c. poor to rich
d. none of the above
3. Wages and prices should most clearly be indexed in countries with
a. high inflation
b. low inflation
c. both
d. neither
4. The cost of this type of inflation are mainly distributional
a. high inflation
b. low inflation
c. anticipated inflation
d. unanticipated inflation
5. The cost of holding this rise along with the inflation rate
a. a salaried job
b. currency
c. bonds
d. stocks
6. Cost-of-living adjustment provisions are an example of
a. housing indexation
b. long-term loans
c. wage indexation
d. costs of inflation
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CONCEPTUAL PROBLEMS
1.
Should zero inflation be a goal? Justify your answer.
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