The inflation rate is based on a price index, which measures the changes in price of a particular selection of goods.

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3 If you cut a worker s wage to half its previous value, but also cut all prices one half of their previous level, the worker s real wage doesn t change. The inflation rate is based on a price index, which measures the changes in price of a particular selection of goods. 3

4 Shoe leather Costs: increased costs of transactions caused by inflation We might expect the student in the example above to be pretty upset about the doubling prices of two goods she really enjoys consuming. What would she do? She might spend a lot of time looking for less expensive substitutes. She might drive around town looking for a coffee shop with prices that haven t doubled. She might decide that she needs to get her $20 of income out of her wallet (where it is quickly becoming worthless) and into something else that might hold value better. All this extra time and effort comes at a cost to the consumer. Shoe leather cost is an allusion to the wear and tear caused by the extra running around that takes place when people are trying to avoid holding money. OR increased cost of transactions caused by inflation. A historical example of this would be the German hyperinflation of Merchants employed runners to take their cash to the bank many times a day to convert it into something that would hold its value, such as a stable foreign currency. This used up valuable resources the time and labor of runners that could have been used productively elsewhere. Menu Cost: the real cost of changing list prices What would the sellers of gas and café lattes need to do? Change their menus or signs. This might not be very expensive for the gas station, they would just need to have the paid employee go outside and change the sign. But the restaurant or coffee shop might need to literally print new menus and this is pretty costly. And what if the price inflation persists? Maybe prices are rising 10% every few months and menus need to be constantly changed as a result. A historical example: During Brazilian inflation in the 1990s, supermarket workers reportedly spent half their time replacing old price stickers with new ones. Unit of Account Cost: costs arising from the way inflation makes money a less reliable unit of measurement These costs can emerge from the way in which we tax certain assets. 4

5 Suppose you owned a house that was worth $100,000 and your state levied a property tax of 1% on that house. Each year you expected to pay $1000 in property taxes. Over the course of a short period of time, maybe two years, real estate prices go way, WAY up. Now your house, on paper, is worth $200,000 but it s the very same house. It s not a better house. Your state reassesses property taxes and now claims that you owe $2000 every year. Assuming your income didn t double as your house was doubling in value, you are worse off because the property tax system didn t take into account that it was inflation that caused your house to increase in value. 4

6 Most contracts lock people into paying a fixed interest rate, regardless of future trends in purchasing power. The interest rate is an extra percentage that borrowers must pay to the lender for the use of the money. Suppose you lend a buddy $100 and he promises to pay you back in a year. There are two reasons why it makes sense to charge him interest. 1. By providing this service to your friend, you won t have that $100 over the next year to buy things that you enjoy. Your service, and delayed consumption, should entitle you to compensation. 2. When he pays you back, inflation will have eroded the purchasing power of the original $100. Knowing this, you should be entitled to enough interest so that inflation doesn t hurt your purchasing power. So the interest rate should have two parts: the part to compensate you for the service you are providing, and the part that offsets the inflation that is expected to occur. Economists call the sum of these two parts the nominal interest rate. Suppose you and your friend agree that inflation next year will be 5% and you agree that your lending services are worth another 3%. You charge your friend: 8% = 3% + 5% After a year s time, three scenarios could have happened. Scenario 1: you expected 5% inflation and you experienced exactly 5% inflation. The purchasing power of the $100 you lent was unchanged when your friend paid you back exactly 5% inflation. The purchasing power of the $100 you lent was unchanged when your friend paid you back exactly enough to compensate for the inflation. 5

7 Scenario 2: you expected 5% inflation and you experienced only 1% inflation. Your purchasing power has actually increased because your friend paid you back more than enough to compensate for the inflation. Note: When actual inflation is below expected inflation, the lender (in this case you) gains and the borrower loses. Scenario 3: you expected 5% inflation and you experienced 8% inflation. Your purchasing power has actually decreased because your friend paid you back less than enough to compensate for the inflation. Note: When actual inflation is above expected inflation, the lender (in this case you) loses and the borrower gains. 5

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9 1. If there is inflation in an economy, firms and households will prefer to spend their money now rather than save. 2. High unanticipated inflation reduces the incentive to save, since it lowers the real interest rate. 3. More spending in the economy contributes to more inflation. Over time, workers will begin t demand higher wages, which further contributes to inflation. 4. An inflationary spiral is when higher prices lead to more spending, which leads to even higher prices and demands among workers for higher wages, contributing to even more inflation. (Demand pull inflation occurs when aggregate demand is greater than aggregate supply. People have money to spend and there simply isn t enough for consumers to buy. ) 7

10 An example of this would be the market for consumer goods during World War II. More people had a steady paycheck, but so many factories had been converted to wartime production that luxury goods were in short supply. When the war ended, this was one of the causes of rapid inflation. 8

11 The result of this leftward shift of the supply curve is higher prices for consumers and a rise in the aggregate price level. The Oil Embargoes of the 1970s are examples. 9

12 Inflation is the overall rise in prices. Deflation is the overall decline in prices. Disinflation is the process of reducing rapid inflation to a smaller, less damaging, amount of inflation. What is painful about disinflation? Often a high rate of inflation is caused by too much money being circulated and spent in the economy. The obvious way to reduce the inflation is to act in ways to reduce the amount of money being circulated and spent. This can be painful because this will often reduce demand for goods and services and put some workers out of work. Most central banks and governments target inflation at around two to three percent. Anything less than that may cause the fear of deflation. Anything greater than that may lead producers and consumers to act in ways that increase the odds of the inflationary spiral shown above. Policy makers in the US have, since the 1980s, tried to maintain a very low and stable amount of inflation so that painful corrections like this are unnecessary. 10

13 Inflation is the overall rise in prices. Deflation is the overall decline in prices. Disinflation is the process of reducing rapid inflation to a smaller, less damaging, amount of inflation. During an economic slump, borrowers are short on cash and will be forced to cut spending sharply when their debt burden rises. However, lenders are less likely to increase spending sharply when the value of they own rise. The overall effect is that deflation reduces spending, deepening an economic slump, which creates a vicious cycle of more deflation. This played a significant role in the Great Depression. 11