Inflation

Inflation

Defined as:– A SUSTAINED RISE IN THE AVERAGE

LEVEL OF PRICES

Types of Inflation

• DEMAND PULL

• WAGE PUSH

• PROFIT PUSH.

Types of Inflation

A. DEMAND PULL

Defined as:

- Excess demand pulls up prices

• Often caused by increases in government spending, such as wars

Types of Inflation

B. WAGE PUSH

Defined as:

- attempts to increase wages faster than productivity

• Often blamed on unions

Types of Inflation

C. PROFIT PUSH

Defined as:

- attempts to increase profits by raising prices

• Often blamed on large corporations

Problems with Inflation

• There are two problems generated by inflation.

A. UNEVENESS

B. UNCERTAINTY

Problems with Inflation

A. UNEVENESS– Inflation produces uneven increases in the

prices of products.– In periods of inflation it is possible of have

some products decrease in price, others increase slowly, while others increase quickly.

Problems with Inflation

A. UNEVENESS– This means that some consumers are hurt

worse than others.– Buyers of gasoline are hit worse than buyers

of DVD’s and computers

Problems with Inflation

A. UNEVENESS– People with fixed incomes will see their

income fall at the same rate as inflation rises.

– Some savers will see their savings fall almost as fast as the rate that inflation

Problems with Inflation

B. UNCERTAINTY

Who else is hurt by the uncertainty and unevenness of inflation?

Lenders – banks, etc.

Problems with Inflation

B. UNCERTAINTY– Lenders lend money to earn a profit.– To earn a profit, the interest they charge must

cover all costs, and be higher than the rate of inflation.

Problems with Inflation

B. UNCERTAINTY– When lenders lend money, they have an

expected rate of inflation at the time of the loan.

– This expected rate of inflation is based on current rate of inflation, plus a guess about the future.

Problems with Inflation

B. UNCERTAINTY– If lenders guess right about inflation, they

earn a profit. – If lenders guess wrong, they lose money.

Problems with Inflation

B. UNCERTAINTY

Nominal interest rate = the observed interest rate

Real interest rate = nominal interest rate –

rate of inflation

Problems with Inflation

B. UNCERTAINTY

Lenders try to set the nominal interest rate to:

1) cover costs

2) match expected rate of inflation

3) yield a profit

Inflation: Any Winners?

Not everyone loses with low and moderate rates of inflation.

- People whose income is flexible.

- Borrowers (debtors).

Inflation: Any Winners?

Borrowers win because the real value of their loan repayments decreases at the same rate as inflation rises.

If their incomes rise as well, they are double winners.

Problems with Inflation

Much of the United States Federal government’s monetary policy, and the focus of most introductory econ textbooks, is on the evils of inflation.

In the dispute between lenders and borrowers, which side are they on?