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 ID: 1027660
Download Presentation The PPT/PDF document "Module 14 Inflation What you will" is the property of its rightful owner. Permission is granted to download and print the materials on this web site for personal, non-commercial use only, and to display it on your personal computer provided you do not modify the materials and that you retain all copyright notices contained in the materials. By downloading content from our website, you accept the terms of this agreement.
1. Module 14Inflation
2. What you will learn in this Module:The economic costs of inflationHow inflation creates winners and losersWhy policy makers try to maintain a stable rate of inflationThe difference between real and nominal values of income, wages, and interest ratesThe problems of deflation and disinflation
3. Inflation does not in itself reduce people’s real purchasing power.The Costs of Inflation: A Fall in Purchasing Power?
4. The Level of Prices Doesn’t Matter…As price levels rise so do nominal wage ratesThis means that your real wage (what your income buys you) hasn’t changed.
5. …But the rate of inflation doesEven 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 costsPrice level changes versuschanges in the inflation rate
6. The Costs of InflationShoe leather costsMenu costsUnit of Account Costs
7. Shoeleather CostsShoeleather 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.
8. Menu CostsMenu 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.
9. Unit of Account CostsInflation 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
10. Winners and Losers from InflationInflation 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 RatesInterest 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.
11. Real and Nominal Interest RatesThe 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)
12. Real and Nominal Interest RatesYou 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.
13. 1965Interest Rates(percent per year)151050-51970197519801985199019951998Nominal interest rateReal interest rateReal and Nominal Interest Rates
14. Who’s Hurt? Who’s Helped?By Unanticipated InflationYou’re hurt if you are aCreditor – the money you loan out is worth less when its paid backSaver – inflation rates are normally higher than interest ratesFixed income receiver- a constant income will buy less.You’re helped if you are aBorrower- the money you are repaying is worth less Flexible income earner- if your income is tied to profits you will earn moreIf your income is adjusted for inflation you will earn more (COLA)Payer of fixed amounts
15. Inflation is easy; Disinflation is hardDisinflation – 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%
16. The Cost of Disinflation