Redistribution
and Output
Effects of
Inflation
Redistribution Effect of Inflation
If we hold Real Output [Real GDP]
constant, and at full-employment
[NRU], we can assess the effect of
inflation on the distribution of income.
Redistribution Effect of Inflation
Real and Nominal Income
Nominal income … is the number of dollars
earned as rent, wages, interest or profit
Real income… measures the amount of
goods and services nominal income can buy.
√ If nominal income rises faster than price
level, real income will rise.
√ If the price level increases faster than
nominal income, then real income will fall.
√ Your real income falls only when nominal
income fails to keep up with inflation.
Unanticipated Inflation
√ Inflation “taxes” those who receive
Loss
relatively fixed incomes:
• elderly and those on fixed pay scales
• welfare recipients
• workers in declining industries, or
without strong unions
√ Inflation takes away purchasing power.
Inflation “subsidizes” some people who
have
Benefit
flexible incomes.
workers in expanding industries and
union members.
Unanticipated Inflation
√ Savers are hurt by inflation.
Loss
• As prices rise, the real value or purchasing power
declines.
• Savers are investing funds and hope to earn
interest.
… If the rate of interest on an investment is
less than the rate of inflation, the value of the
savings will decline.
• Savings accounts, insurance policies, annuities,
and other fixed value paper assets are hurt by
inflation.
Unanticipated Inflation
Loss
Creditors are losers in inflation since they
are “stuck” with dollars that have lower
purchasing power than the money they lent.
Debtors are winners in inflation at the
expense of creditors. The borrower
Benefit receives “dear” money at the time the
loan is initiated and repays the loan
with “cheap” dollars.
Unanticipated Inflation
Those who benefit Those who lose
Flexible Income
Fixed Income
Spenders??
Savers
Debtors
Creditors
Anticipated Inflation
√ Inflation is less severe if
… anticipate inflation
… adjust income to reflect the price
level changes.
√ Cost of living adjustments (COLA’s) clauses
in labor contracts give automatic wage
increases when inflation occurs.
√ Lenders can charge higher interest on loans if
they have high expectations for inflation over
the life of the loan. This extra interest is called
inflation premium.
Anticipated Inflation
Inflation Premium—the expected rate of inflation
11%
+
=
5%
Nominal
Interest
Rate
Real
Interest
Rate
6%
Interest
Premium
Redistribution Effect of Inflation
Deflation…effects described above are now
reversed. Fixed income earners, creditors,
and savers will all be better off.
Mixed Results
… we gain and we
lose since we all
wear many hats —
income earner,
saver, creditor,
debtor, etc.
Arbitrariness…
effects of inflation
occur regardless of
society’s goals and
values.
Output Effects of Inflation
Cost-Push Inflation and Unemployment
√ If cost-push inflation occurs in a full
employment, the existing level of total
spending will buy less real output because of
the higher price level.
√ Real output would fall and
unemployment will rise.
√ The cost-push inflation of the 1970’s
was caused of the oil shocks throughout the
decade.
Output Effects of Inflation
Stimulus of
Demand-Pull
Inflation
P
r
i
c
e
l
e
v
e
l
Range 3
Range 2
Range 1
Increases in total spending
Quantity
Qf
In range 2 there is a tradeoff between output and
employment and inflation. Some moderate amount
of inflation must be accepted if we are to realize high
levels of output and employment.
Output Effects of Inflation
Hyperinflation and Breakdown
√ Hyperinflation is extremely rapid
inflation that can devastate domestic output
levels and employment
√ Anticipation of future inflation catches
hold of the thinking of consumers and firms
who make buying and selling decisions in
expectation of the coming inflation.
Output Effects of Inflation
√ Labor will demand higher wages, and
businesses not wanting to risk their
prosperity will give in. But…they must raise
prices to cover the new cost and the wageprice spiral whirls out of control. Creeping
inflation becomes a runaway gallop.
√ Economic collapse results often since
speculation is rampant. Hoarding and
concentration of wealth in “real assets” like
gold, jewels, and other metals replaces
investment in new capital for businesses.