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MODULE 14 Inflation: An Overview

MODULE 14 Inflation: An Overview. 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

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MODULE 14 Inflation: An Overview

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  1. MODULE 14 Inflation: An Overview

  2. 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

  3. The Natural Rate of Unemployment • The real wage is the wage rate divided by the price level. • Real income is income divided by the price level. • The inflation rate is the percent increase in the overall level of prices per year. Price level in year 1

  4. Inflation and Deflation In the 2000s, the overall level of prices in the United States was much higher than it was in 1969—but that, as we’ve learned, didn’t matter. The inflation rate in the 2000s, however, was much lower than in the 1970s—and that almost certainly made the economy richer than it would have been if high inflation had continued.

  5. Costs of Inflation • High rates of inflation impose significant economic costs. • Shoe-leather costs are the increased costs of transactions caused by inflation. • A high inflation rate discourages holding money. WHY? • This leads people to search for ways to reduce the amount of money they hold, often at considerable economic cost. • Hyper-inflation during the early 1990s caused the Brazilian banking sector to grow so large that it accounted for 15% of GDP.

  6. Costs of Inflation • Menu cost is the real cost of changing a listed price. • For example, to change a price in a supermarket may require a clerk to change the price listed under the item on the shelf and an office worker to change the price associated with the item’s UPC code in the store’s computer.  • In the face of inflation firms are forced to change prices more often than they would if the price level was more or less stable. This means higher costs for the economy as a whole.

  7. Costs of Inflation • Unit-of-account costs arise from the way inflation makes money a less reliable unit of measurement. • A family planning its budget • A business contract requiring paying off debt within a certain period. • While the inflation rate is 10% per year, a business buys an asset, such as a piece of land, for $100,000 and then resells it a year later at a price of $110,000.

  8. Winners and Losers from Inflation • Inflation changes the dollar repayment of a loan because the loan contract is stated in nominal terms. • The nominal interest rate is the interest rate expressed in dollar terms. • The real interest rate is the nominal interest rate minus the rate of inflation. • If inflation is higher than expected, borrowers gain at the expense of lenders. • Lender loans out money at 5% interest rate thinking the inflation would be 2%. What is the lenders expected return? • If inflation is lower than expected, lenders gain at the expense of borrowers.

  9. Inflation is Easy; Disinflation is Hard • Disinflation is the process of bringing the inflation rate down. • https://www.npr.org/sections/money/2015/12/02/458222801/episode-216-how-four-drinking-buddies-saved-brazil

  10. Inflation and Deflation

  11. Israel’s Experience with Inflation • In the mid-1980s, Israel experienced a “clean” inflation. • But policy errors led to very high inflation. • The shoe-leather costs of inflation were substantial. Israelis spent a lot of time moving money in and out of bank accounts that provided high enough interest rates to offset inflation. • Businesses made efforts to minimize menu costs. For example, restaurant menus often didn’t list prices. • It was hard for Israelis to make decisions because prices changed so much and so often.

  12. The rate of change of prices is important in the economy. • A high inflation rate imposes overall costs on the economy: shoe-leather costs, menu costs, and unit-of-account costs. • Inflation does not, as many assume, make everyone poorer by raising the level of prices because wages and incomes are adjusted to take into account a rising price level, leaving real wages and real income unaffected. • A higher-than-expected inflation rate is good for borrowers and bad for lenders. A lower-than expected inflation rate is good for lenders and bad for borrowers. • Disinflation is very costly, so policy makers try to prevent inflation from becoming excessive in the first place.

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