Module 14: Inflation
The Level of Prices Doesn’t Matter… But the Rate of Change of Prices Does!
Inflation creates costs for everyone
1. Shoe Leather Costs – What would our coffee lover from our example do?
Might spend time looking for cheaper alternatives, driving around town looking for
coffee that hasn’t doubled in price. He/She might also look to get their $20 into
something else that won’t lose its value so quickly.
This cost is an allusion to the wear & tear of all the running around we do to keep
from holding our money. All of the extra time & effort comes at a cost to the
consumer.
2. Menu Costs – What would the gas station and the Starbuck’s have to do?
They would have to change their prices on their signs & menus. Gas stations are used
to this & thus they have a sign that is easy to change but most restaurants/food &
beverage outlets have menus or more permanent signage that could be costly to
change.
These are costs incurred by the seller just to update posted prices. It could be very
costly if there is persistant high inflation.
3. Unit-of-Account Costs – These costs come from the way high inflation causes our
currency to be less useful as a unit of measure.
Let’s say that there is hyperinflation and you are trying to buy some clothes at the
mall. Ordinarily you know what your $100 can purchase but if prices are constantly
changing, you really have no idea what your $100 will be able to buy. (if anything)
Winners and Losers from Inflation – Sometimes inflation can redistribute money
from one person to another, especially when we look at lenders and borrowers.
If loan $100 to a “friend” for a year, there are 2 reasons why you would charge them
interest.
1. You will not have that $100 for a whole year! Your service (delayed consumption)
should be compensated.
2. Inflation most-likely will have increased and thus your purchasing power would
have been hurt. The interest will help to cover the loss of purchasing power of the
$100.
The interest rate you charge should have 2 parts that will add up to be the nominal
interest rate:
Nominal Interest Rate = Real Interest rate + Inflation
Let’s say you agree that Inflation will go up 3% over the next year and that you will
charge 2% for your loan services.
5% = 2% + 3%
After the year is up, a few different things could have happened:
1. The economy experiences exactly 3% inflation: The $105 dollars you get paid
back compensates you for inflation and your services just as you had hoped. All
are happy 
2. The economy only experiences 1% inflation over the year: Your purchasing
power has actually increased because your friend has paid you back more than
you needed to compensate for inflation. Lender Wins!
3. The economy experiences 5% inflation over the year: Your prchasing power
hs now decreased because your friend has not paid you enough to compensate for
the high inflation. Borrower Wins!
A few terms to be familiar with:
Inflation – Overall rise in prices
Deflation – Overall decline in prices
Disinflation – the process of reducing rapid inflation to a smaller, less damaging
amount. This is painful!
Since the 80’s, policymakers have made it a priority to keep inflation low to avoid this
issue.