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.

The Importance of Low Inflation when price changes are expected and predictable, but not uniform.

Type 2: Expected & predictable price changes that are not uniform

Wages & salaries rise less frequently than the prices of goods & services

A bigger problem with inflation is that prices do not rise uniformly. Inflation causes most people to lose purchasing power because their income lags behind increases in the prices of goods and services. Purchasing power refers to the value of the products a person is able to buy with a given amount of money. People are not able to purchase as many goods and services with their income as prices rise.




How Purchasing Power Has Changed in the Last Century
$100 in 1915 had the same purchasing power as $1913.86 in 2005
$100 in 1920 had the same purchasing power as $ 966.50 in 2005
$100 in 1925 had the same purchasing power as $1104.57 in 2005
$100 in 1930 had the same purchasing power as $1157.49 in 2005
$100 in 1935 had the same purchasing power as $1410.95 in 2005
$100 in 1940 had the same purchasing power as $1380.71 in 2005
$100 in 1945 had the same purchasing power as $1073.89 in 2005
$100 in 1950 had the same purchasing power as $ 802.07 in 2005
$100 in 1955 had the same purchasing power as $ 721.27 in 2005
$100 in 1960 had the same purchasing power as $ 653.04 in 2005
$100 in 1965 had the same purchasing power as $ 613.65 in 2005
$100 in 1970 had the same purchasing power as $ 498.20 in 2005
$100 in 1975 had the same purchasing power as $ 359.29 in 2005
$100 in 1980 had the same purchasing power as $ 234.59 in 2005
$100 in 1985 had the same purchasing power as $ 179.65 in 2005
$100 in 1990 had the same purchasing power as $ 147.90 in 2005
$100 in 1995 had the same purchasing power as $ 126.84 in 2005
$100 in 2000 had the same purchasing power as $ 112.25 in 2005
$100 in 2005 had the same purchasing power as $ 100.00 in 2005
Table . Inflation causes a significant loss of purchasing power.
Source: U.S. Bureau of Labor Statistics
http://data.bls.gov/cgi-bin/cpicalc.pl




People do not lose purchasing power if their incomes are indexed. Indexation is using a law or contract to automatically correct a dollar amount for the effects of inflation. For example, Social Security benefits use cost-of-living adjustments (COLAs), which are indexed to the Consumer Price Index (CPI) and automatically increase with increases in inflation.

Year
COLA
Year
COLA
1975
8.0%
1991
3.7%
1976
6.4%
1992
3.0%
1977
5.9%
1993
2.6%
1978
6.5%
1994
2.8%
1979
9.9%
1995
2.6%
1980
14.3%
1996
2.9%
1981
11.2%
1997
2.1%
1982
7.4%
1998
1.3%
1983
3.5%
1999
2.5%*
1984
3.5%
2000
3.5%
1985
3.1%
2001
2.6%
1986
1.3%
2002
1.4%
1987
4.2%
2003
2.1%
1988
4.0%
2004
2.7%
1989
4.7%
2005

1990
5.4%
2006

Table . Cost-of-living adjustments (COLAs) automatically increase Social Security benefits to compensate for the loss in purchasing power caused by inflation as measured by the Consumer Price Index (CPI).
Source: The Social Security Administration
http://www.ssa.gov/OACT/COLA/colaseries.html

*The COLA for December 1999 was originally determined as 2.4 percent based on CPIs published by the Bureau of Labor Statistics. Pursuant to Public Law 106-554, however, this COLA is effectively now 2.5 percent.

Most people's incomes are not indexed, however. Consequently inflation harms most people by reducing their purchasing power, at least temporarily.




Expectations of future price increases

Another damaging component of inflation is its effect on expectations. If people think the prices of goods and services will increase before their incomes rise, then workers may push for higher wages and salaries now in anticipation of higher prices of goods and services in the future. Higher labor costs represent higher costs of production for businesses. These companies are then forced to raise product prices to cover these higher labor costs. This pushes inflation even higher, forcing another round of expectations of higher prices. Expectations of higher prices cause the price level to rise more rapidly than it would otherwise.

Inflation creates confusion that leads to inefficient purchasing decisions

Inflation also creates confusion and makes if difficult for people to have accurate price information when making purchasing decisions. When inflation is low, prices remain relatively constant. This allows people to develop a sense of the appropriate prices of products. Is one dollar per pound a good price for bananas? How about two dollars per gallon of gasoline? Is five dollars per gallon of milk a bargain price? During periods of high inflation, prices change rapidly so it is difficult for people to learn appropriate prices. People may not know if the price of a product has gone up because the seller is seeking excess profits or just because it reflects current inflation.


In the real world, prices do not change uniformly. Individual companies make decisions about when to change prices and by how much. These changes are usually in response to market conditions. Nonetheless, prices in various markets do not change by the same amount every day. This can lead to a misallocation of resources.

The Importance of Low Inflation when price changes are expected, predictable, and uniform.

The Importance of Low Inflation when price changes are expected, predictable, and uniform.

Type 1: Expected, predictable, uniform price changes.

If price changes are expected, predictable, and uniform, then their effects are relatively small. If inflation caused the prices of everything to rise at the same rate, inflation would not be so bad. It would create a few inefficiencies, however, such as the shoe leather and menu costs of inflation and an increase in the tax burden on personal investments. These costs occur with any type of inflation. What makes these costs unique, however, is that they occur even when inflation is expected, predictable and uniform.

Suppose the prices of everything in the economy double each year. Suppose wages and prices double on January 1st and remain at that level throughout the year. The week after January 1st, everyone’s income is twice as big as it was the week before. Are people better off? Because prices have also doubled, everyone’s purchasing power has stayed the same. For example, if you have $1 and a Coke costs 50 cents, then you can buy two of them. If you have $2 and a Coke costs $1, you still can buy only two of them. Your purchasing power has not changed.

The shoe leather costs of inflation

Inflation does cause people to alter their behavior, however. One form of altered behavior creates the shoe leather costs of inflation. Inflation causes people to hold less cash than in the absence of inflation. Consider the extremely high rates of inflation known as hyperinflation. If prices are increasing at a rate of 50% per month, then any cash a person carries around loses purchasing power at the same rate. If a pair of shoes costs $100 at the beginning of the month, then its price rises to $150 at the end of the month. In order to avoid the loss of purchasing power, people will tend to leave money in savings accounts where it will earn a nominal rate of interest that will keep up with the inflation rate. (Remember that nominal interest rates increase with the inflation rate.) Money loses its power as a store of value during periods of high inflation. In periods of high inflation, people have an incentive to carry less cash. This may cause them to make more frequent trips to the bank. The shoe leather costs of inflation are the wasted time and inconveniences caused when inflation encourages people to reduce their holdings of currency. The name is derived from the extra wear that would occur to people’s shoes if they walked to the bank every time they needed to withdraw cash to buy something. Modern banking conveniences, such as debit cards, have reduced the significance of the shoe leather costs of inflation.

The menu costs of inflation

Inflation also causes businesses to pay increased menu costs. The menu costs of inflation are the costs associated with changing the prices of the products sold by a business. These include the resources devoted to recalculating prices and publicizing the new prices to potential customers. The name is derived from the additional cost of printing new menus more frequently during periods of high inflation. If inflation is low, a restaurant might print new menus once or twice per year. During periods of hyperinflation, however, the restaurant might print new menus several times per week. Menu costs are significant for some businesses, such as those that rely on catalogs to generate sales.

The Importance of Low Inflation

The Importance of Low 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.

To understand the importance of low inflation, it helps to consider three types of changes in the price level: (1) expected, predictable, uniform price changes; (2) expected and predictable price changes that are not uniform; and (3) price changes that are unexpected and unpredicted.