chapter:
8
>> Inflation
Krugman/Wells
©2009  Worth Publishers
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WHAT YOU WILL LEARN IN THIS CHAPTER
 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.
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Inflation and Deflation

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The real wage is the wage rate divided by the price
level.
Real income is income divided by the price level.
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Inflation and Deflation
The Price Level versus the Inflation Rate, 1968-2008
Price
Level
Inflation
rate
250
16%
14
200
12
10
150
8
100
6
4
50
2
1968
2008
1970
1980
1990
2000
Year
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Inflation problems

Shoe-leather costs are the increased costs of
transactions caused by inflation.


Allusion to the wear and tear caused by extra running
around that takes places when people are trying to avoid
holding money.
Menu cost is the real cost of changing a listed
price.

In a supermarket, to change a price requires a clerk to
change the price on the shelf, office worker to change
price associated with UPC.
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►ECONOMICS IN ACTION
Israel’s Experience with Inflation





In the mid-1980s, Israel experienced a “clean” inflation:
there was no war, the government was stable, and there
was order in the streets.
But policy errors led to very high inflation.
The shoe-leather costs of inflation were substantial. Israelis
spent a lot of time moving money in and out of bank
accounts that provided high enough interest rates to offset
inflation.
Businesses made efforts to minimize menu costs. For
example, restaurant menus often didn’t list prices.
It was hard for Israelis to make decisions because prices
changed so much and so often.
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Inflation problems

Unit-of-account costs arise from the way inflation
makes money a less reliable unit of measurement.

State contracts in terms of monetary units and make
budgets based on money in or out.
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Inflation winners & losers


The nominal interest rate (i) the interest rate
actually paid for a loan, not adjusted for inflation.
The real interest rate (r) is the nominal interest
rate minus the rate of inflation.
r = i – inflation rate
OR
i = r + inflation rate
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Inflation winners & losers




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People on fixed income
People who loan money
People who borrow money
People who are retired
People with contracts tied to COLAs
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Disinflation and Deflation

Disinflation is the process of bringing the inflation
rate down.
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Inflation and Deflation
The Cost of Disinflation
Inflation
rate
Inflation
rate
12%
16%
14
12
10
10
8
8
6
6
4
2
1978
1980
1982
1984
1986
Year
1988
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SUMMARY
1. Policy makers worry about inflation as well as
unemployment.
2. Inflation does not, as many assume, make everyone
poorer by raising the level of prices. That's because wages
and incomes are adjusted to take into account a rising
price level, leaving real wages and real income
unaffected. However, a high inflation rate imposes overall
costs on the economy: shoe-leather costs, menu costs,
and unit-of-account costs.
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SUMMARY
3. Inflation can produce winners and losers within the
economy, because long-term contracts are generally
written in dollar terms. Loans typically specify a nominal
interest rate, which differs from the real interest rate due
to inflation. A higher-than-expected inflation rate is good
for borrowers and bad for lenders. A lower-than expected
inflation rate is good for lenders and bad for borrowers.
4. Disinflation is very costly, so policy makers try to prevent
inflation from becoming excessive in the first place.
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End of Inflation
coming attraction:
Calculation of Inflation
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