Module 14 – Inflation: An Overview

1. Inflation and Deflation
   1. The Level of Prices Doesn’t Matter

i.      The real wage is the wage rate divided by the price level.

ii.      Real income is income divided by the price level.

iii.      Rise in prices doesn’t affect wealth, because income has risen by the same amount.

1. But the Rate of Change of Prices Does Matter

i.      The inflation rate is the percent change per year in a price index – typically the consumer price index.

ii.      Inflation rate = Price level in year 2 – Price level in year 1 / Price lvl year 1 X 100

iii.      Shoe-Leather Costs

1. A high inflation rate discourages people from holding money, because the purchasing power of the cash in your wallet and the funds in your bank account steadily erodes as the overall level of prices rises.
2. Shoe-leather costs are the increased costs of transactions caused by inflation.

iv.      Menu Costs

1. Menu costs are the real costs of changing listed prices.
2. In the face of inflation, firms are forced to change the prices more often than they would if the price level was more or less stable.

v.      Unit-of-Account Costs

1. Unit-of-account costs arise from the way inflation makes money a less reliable unit of measure.
2. It’s role can be degraded by inflation, which causes the purchasing power of a dollar to change over time – a dollar next year is worth less than a dollar this year.
3. The economy as a whole makes less efficient use of its resources because of the uncertainty caused by changes in the unit of account, the dollar.
4. Winners and Losers from Inflation

i.      A high inflation rate imposes overall costs on the economy.

ii.      Inflation can produce winners and losers within the economy.

1. Contracts that extend over a period of time and these contracts are normally specified in nominal terms.

iii.      The interest rate on a loan is the percentage of the loan amount that the borrower must pay to the lender, typically on an annual basis, in addition to the repayment of the loan amount itself.

1. Economists summarize the effect of inflation on borrowers and lenders by distinguishing between nominal interest rates and real interest rates.
   1. The nominal interest rate is the interest rate actually paid for a loan.
   2. The real interest rate is the nominal interest rate minus the rate of inflation.

i.      Example: If a loan carries a nominal interest rate of 8%, but the inflation rate is 5%, the real interest rate is 8%-5% = 3%.

1. If the actual inflation rate is higher than expected, borrowers gain at the expense of lenders: borrowers will repay their loans with funds that have a lower real value than had been expected. If the inflation rate is lower than expected, lenders will gain at the expense of borrowers: borrowers must repay their loans with funds that have a higher real value than had been expected.
2. Uncertainty about the future inflation rate discourages people from entering into any form of long-term contract.
3. Unexpected deflation – a surprise fall in the price level – creates winners and losers, too.
4. Inflation is Easy, Disinflation is Hard

i.      Disinflation is the process of bringing the inflation rate down.

1. Very difficult and costly once a higher rate of inflation has become well established in the economy.