Thursday, October 9, 2008

The Importance of Low Inflation when price changes are unexpected and unpredictable.

Type 3: Price changes that are unexpected and unpredicted

Unexpected inflation redistributes income from lenders to borrowers.

There is an additional cost of inflation if the price changes are unexpected. Unexpected inflation redistributes income from lenders to borrowers. Unexpected deflation, by contrast, redistributes income from borrowers to lenders. Loans charge an interest rate that is variable or fixed. Variable rate loans allow the lender to periodically adjust the nominal interest rate to correct for changes in the inflation rate. Fixed rate loans, however, commit the lender to pay the stated nominal rate of interest for the life of the loan. If lenders expect inflation to occur, they include it in the nominal interest rates charged to borrowers. Unexpected inflation reduces the real rate of return, however. In October 2003, a typical interest rate on a 30-year fixed-rate mortgage loan was around 6% per year. The inflation rate during that month was estimated to be about 2% per year. Thus, the real interest rate was about 4% per year. (real interest rate = nominal interest rate – inflation rate) If the inflation rate increases unexpectedly to 5% per year, then the real rate of interest drops to only 1% per year. The borrower is paying a smaller real interest rate than the lender had expected. Thus, borrowers tend to benefit from unexpected inflation, while lenders lose from it. Borrowers pay back the loan with dollars that have less purchasing power than the lender had expected.

When lenders are burned by unexpected inflation, they may attempt to create a larger cushion between the nominal and real interest rates. This is sometimes referred to as a risk premium. Thus inflation can cause real interest rates to rise. This discourages businesses and households from borrowing money for investment projects. Reduced investment leads to lower productivity and reduced economic growth.

Inflation creates uncertainty that discourages long-term investment

The largest cost of inflation may be the effect it has on investment in the economy. Inflation creates an environment of uncertainty, especially when the inflation rate fluctuates. Historically, high inflation rates are rarely constant and predictable. This may make businesses reluctant to proceed with some investment projects (e.g., new factories).

If businesses expect prices to remain steady over the upcoming decade or two, they will be much more inclined to engage in a long-term investment project. Suppose analysts tell the Trek bicycle executives that the company could earn an additional $1 million in each of the next 10 years if they build a new bicycle manufacturing plant in Jacksonville, Florida. If inflation causes erratic changes in the price level, however, Trek executives may have difficulty determining if $1 million per year will be a good rate of return 10 years from now. This uncertainty may make them less inclined to build the new factory.

Since investment (in physical capital, human capital, and technology) is the key to increased productivity and economic growth, inflation can reduce the future standard of living if it causes a reduction in investment.

To illustrate how inflation creates uncertainty, consider two scenarios. In one scenario, imagine that inflation was low and persistent throughout the twentieth century. This would lead most people to predict that inflation will stay low in the coming decades. In the second scenario, imagine that the price level fluctuated wildly throughout the twentieth century. This makes it difficult to reach a consensus on the expected price level in the future. The price level could rise quickly, rise slowly, stay relatively constant, or even fall.




Price
? Level
Unpredictable inflation



Persistent low inflation
?
?
?













Year

Figure 2. Hypothetical inflation rates.
Persistent low inflation leads to more confidence about future price levels than unpredictable inflation.



Inflation is bad because it imposes costs on society that could be avoided in the absence of inflation. These costs generally result in reduced economic growth and lower present and future standards of living. These costs can be minimized if the economy maintains a low inflation rate.

In order to keep inflation low, it helps to understand the types of inflation and their causes. The appropriate policy prescription depends upon the source of the inflation.

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