Name _______________________________
Section 3
Module 14: Inflation: An Overview
Lecture Notes
Pump Primer
Define inflation and deflation.
Learning objectives:
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The economic costs of inflation
How inflation creates winners and losers
Why policy makers try to maintain a stable rate of inflation
The difference between real and nominal values of income, wages, and interest rates
The problems of deflation and disinflation
Key Economic Concepts for This Module:
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Rapid inflation imposes costs on society in the form of: shoe-leather, menu and unit-of-account
costs.
Nominal interest rate = real interest rate + expected inflation
Unexpectedly high rates of inflation benefit borrowers and hurt lenders. Unexpectedly low rates of
inflation hurt borrowers and benefit lenders.
If the inflation rate gets too high, the process of reducing (disinflation) can be painful for the
economy.
Introduction:
The purpose of this module is to introduce inflation and how it can, particularly when it is unexpected, create
winners and losers in the economy. The module also differentiates between real and nominal income, wages
and interest rates, which are important topics later in the course.
The Level of Prices Doesn’t Matter...
(NOTE: Economists often toss around little phrases like “there’s no such thing as a free lunch.” Another
phrase that is pertinent to this material is “only relative prices matter.”)
Example A student in the class has an income of $20 per week to spend on gasoline ($2 per gallon) or venti
mochaccino café lattes (at $4 per cup). We can see her purchasing possibilities in a table below.
The most gas she could
buy:
The most lattes she could
buy:
To buy one more latte, she must
give up
10 gallons of gas
5 cups
2 gallons of gas
One gallon of gas uses up 10% of her income.
One cup of latte uses up 20% of her income.
What would happen if her income doubled and so did the price of gasoline and the price of a café
latte? Absolutely nothing!
The prices of gas and café lattes, relative to her income is unchanged.
The price of a cup of latte, relative to the price of a gallon of gas is unchanged.
Nothing REAL has changed.
...But the Rate of Change of Prices Does
_________________ rate = (Price level in year 2 - Price level in year 1) / (Price level in year 1) x 100
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What if the price of gas and café lattes doubles, while the student’s income stays the same?
The most gas she could
buy:
The most lattes she could
buy:
To buy one more latte, she must
give up
5 gallons of gas
2.5 cups
____ gallons of gas
One gallon of gas uses up 20% of her income.
One cup of latte uses up 40% of her income.
The price of a cup of latte, relative to the price of a gallon of gas is unchanged. However, relative to
her income, these items are now twice as costly!
Obviously, this price inflation has radically ___________________ her purchasing power because
her income did not rise to keep pace.
In a very REAL sense, she is ___________off.
What would she do? What would the sellers of gas and café lattes do?
Inflation creates costs for both groups of people.
1. __________ _______________ costs
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
become worthless) and into something else that might hold value better.
All of this extra time and effort comes at a cost to the ___________________.
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 costs of transactions caused by inflation.
2. ________________ Costs
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 a paid employee go outside and change the sign.
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Whereas, a restaurant or coffee shop might need to literally print new menus and this is costly.
What if this price inflation persists? Maybe prices are rising 10% every few months and menus
need to be constantly changed as a result.
These are costs incurred by the sellers just to update the posted prices.
3. _________-_____-_______________ Costs
The costs arising from the way inflation makes money a ________ reliable unit of measurement.
These costs can emerge from the way in which we tax certain assets.
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 ___________
off because the property tax system didn’t take into account that it was inflation that caused your
house to increase in value.
Winners and Losers from Inflation
(Note: Inflation can often just redistribute money from one person to another. A good example of this can be
seen when we look at borrowers and lenders.)
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Suppose you lend a buddy $100 and he promises you 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.
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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.
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Economists call the sum of these two parts the nominal interest rate:
Nominal interest rate = real interest rate + expected inflation
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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: ____________
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After a year’s time, three scenarios could have happened.
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Scenario 1: You expected 5% inflation and you experienced exactly 5% inflation. The purchasing power
of the $100 you lent was _______________ when your friend paid you back exactly enough to
compensate for the inflation.
Scenario 2: You expected 5% inflation and you experienced only 1% inflation. Your purchasing power
has actually _________________ 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) __________
and the borrower ___________.)
Scenario 3: You expected 5% inflation and you experienced 8% inflation. Your purchasing power has
actually ___________________ 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) ___________
and the borrower ___________.)
Inflation is Easy; Disinflation is Hard
Disinflation
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A quick review of terms:
o
_____________________ is the overall rise in prices.
o
_____________________ is the overall decline in prices.
o
_____________________ is the process of reducing rapid inflation to a smaller, less damaging,
amount of inflation.
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Disinflation would be necessary if inflation was 10% and policy makers acted to bring it
down to 3%.
What is problematic 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.
 Policymakers in the U.S. have, since the 1980s, tried to maintain a very low and stable
amount of inflation so that painful corrections like this are unnecessary.
Common Student Difficulties:
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Students can assume that inflation hurts everyone in the economy, when it fact it can serve as a
distribution of income from those that are hurt, to those that gain, from rising prices.
The difference between nominal and real values is important.
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