The Costs of Inflation

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The Costs of Inflation
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Wages and prices rise and fall together.
Inflation does not erode real wages.
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Inflation and Real Wages
But you believe that you earned 5 and
inflation robbed you of 2

• Increase in wages Increase in productivity
  increase in prices
• Example
• Increase in productivity 3
• Inflation 2
• Increase in wages 23 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.

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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 clothing increase 3 but wages paid to
your workers rise 2
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
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Redistribution of Income

• People on fixed incomes (pensions, welfare) lose
  purchasing power
• Individuals whose incomes grow slower than
  inflation (minimum wage) lose purchasing power.

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The Cost of Unanticipated Inflation

• Unanticipated inflation when your guess about
  inflation turns out to be wrong.

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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.

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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.

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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

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The Real Interest Rate

• Real Interest Rate Nominal Interest Rate
  Inflation Rate.

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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)

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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

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Year Index Inflation
1996 100.52 0.2
1997 101.05 0.5
1998 101.98 0.9
1999 100.79 -1.2
2000 99.85 -0.9
2001 98.78 -1.1
2002 124.33 25.9
2003 141.05 13.4
2004 147.28 4.4
2005 161.48 9.6
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Year Index 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
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Colombia
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Ecuador
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Venezuela
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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.

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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.

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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)

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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.

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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 governments failure to
  index transfers to the poor and tax real instead
  of nominal returns.

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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.