INFLATION

What is inflation?

What is inflation?
Defined:
General increase in price level /
decrease in moneys purchasing
power
Price level = average current price of
all goods and services in an economy

What is inflation?
Assume that you have $20 / week to
spend on gas ($2/gallon) or venti
lattes ($4/cup).
How much gas COULD you buy?
10 gallons
How many lattes COULD you buy?
5 cups
What would happen if your income
doubled and so did the price of
gasoline and the price of a latte?

What is inflation?
What if the prices of both goods
double, while your income stays the
same?
Most gas you could buy?
5 gallons

Most lattes you could buy?

2.5 cups

Your purchasing power has

decreased as price level has
risen.

What causes
inflation?
1. Increase in the money
supply
2. Decrease in the supply
of goods
3. Demand for money
decreases
4. Demand for goods and
services increases

Who wins and loses

with inflation?
Inflation becomes a problem when
we are unable to predict it
Usually with inflation, what we see is
redistribution of money in the
economy
Borrowers / those in debt tend to
benefit
Lenders / savers lose

Who wins and loses

with inflation?
The interest rate attached to a loan
should have two parts:
the part to compensate you for the
service you are providing
the part that offsets the inflation that is
expected to occur
Economists call the sum of these two
parts the nominal interest rate:
Nominal interest rate = real interest
rate + expected inflation

Who wins and loses

with inflation?
You charge your friend 8% interest to
borrow $100.
(3% for your services + 5% expected )

Scenario 1: You expected 5% inflation

and you experienced exactly 5%
inflation. The purchasing power of
the $100 you lent was unchanged
when your friend paid you back

Who wins and loses

with inflation?
You charge your friend 8% interest to
borrow $100.
(3% for your services + 5% expected )

Scenario 2: You expected 5% inflation

and you experienced only 1%
inflation. Your purchasing power has
actually increased because your
friend paid you back more than

Who wins and loses

with inflation?
You charge your friend 8% interest to
borrow $100.
(3% for your services + 5% expected )

Scenario 3: You expected 5% inflation

and you experienced 8% inflation.
Your purchasing power has actually
decreased because your friend paid
you back less than enough to

Who wins and loses

with inflation?
Assume the economy experiences
unanticipated inflation.

A farmer buys machinery with a

fixed-rate loan to be repaid over a
10-year period.

HEL
HUR
Does the unanticipated inflation
P
the farmer?
Tor

Who wins and loses

with inflation?
Assume the economy experiences
unanticipated inflation.

Your savings from your summer job

are in a savings account paying a
fixed rate of interest.
Does the unanticipated inflation
HEL
or
you?
HUR
P

Who wins and loses

with inflation?
Assume the economy experiences
unanticipated inflation.

The federal government has a

$5,000,000,000 debt.
Does the unanticipated inflation
HEL
or
the government?
HUR
P

Who wins and loses

with inflation?
Assume the economy experiences
unanticipated inflation.

Parents are putting savings for their

childs college education in a bank
savings account.
Does the unanticipated inflation
HEL
or
the family?
HUR
P

???