Topic 2.5 Notes – Costs of Inflation

1. Unexpected Inflation and Deflation

• Inflation = sustained rise in the general price level
• Deflation = sustained fall in the general price level
• Unexpected (unanticipated) means actual inflation ≠ expected inflation

The word unexpected is everything here.

If inflation is expected:

• Lenders build it into higher nominal interest rates.
• Workers negotiate cost-of-living adjustments (COLAs).
• Contracts adjust.

If inflation is unexpected:

• Contracts are already fixed.
• Real outcomes change.
• Wealth gets redistributed arbitrarily.

That redistribution is the core testable idea.

2. Redistribution Between Borrowers and Lenders

This is the most important cost.

Nominal vs. Real Interest Rate

• Nominal interest rate = stated rate in the contract
• Real interest rate = nominal rate − inflation rate

$$\text{Real interest rate} = \text{Nominal rate} - \text{Inflation rate}$$

If actual inflation is higher than expected, the real interest rate falls.

Unexpected Inflation (higher than expected)

Suppose:

• Expected inflation = 2%
• Nominal interest rate = 5%
• Expected real rate = 3%

If actual inflation turns out to be 6%:

• Real interest rate = 5% − 6% = −1%

Borrowers repay loans with dollars that have less purchasing power.

Result:

• ✔️ Borrowers gain
• ❌ Lenders lose

Real-world anchor:

• During the 1970s high inflation, many fixed-rate borrowers benefited.
• The U.S. government, with large Treasury debt, benefits from unexpected inflation because it repays in cheaper dollars.

Unexpected Deflation (or lower-than-expected inflation)

If inflation is lower than expected, or prices fall:

• Real interest rate rises.
• Debt becomes more expensive in real terms.

Result:

• ✔️ Lenders gain
• ❌ Borrowers lose

Historical anchor:

• During the Great Depression, deflation increased real debt burdens.
• Farmers and households were crushed by rising real debt.

Shortcut to remember:

• Inflation helps borrowers, hurts lenders.
• Deflation helps lenders, hurts borrowers.
  (Assume fixed rates unless told otherwise.)

3. Other Groups Helped or Hurt

Redistribution doesn’t stop with loans.

Hurt by Unexpected Inflation

• Savers
  • Money in a savings account loses purchasing power.
  • Retirees living on fixed savings are especially vulnerable.
• Workers on fixed incomes
  • Pension recipients without COLAs.
  • If wages don’t rise as fast as prices → real income falls.
• Lenders with fixed-rate loans
  • Lower real return than expected.

Helped by Unexpected Inflation

• Borrowers with fixed-rate loans
  • Mortgage holders, student loan borrowers.
• Owners of real assets
  • Real estate and stocks often rise in nominal value.
  • Their wealth adjusts with inflation.
• Firms that can lower real wages
  • If nominal wages stay the same but prices rise → real wages fall.
  • Labor becomes cheaper in real terms.

Variable-rate loans adjust for inflation, so redistribution is smaller there.

On AP questions, always ask: Was the contract fixed?

4. Menu Costs and Shoe-Leather Costs

These are inefficiencies caused by inflation.

Menu Costs

Costs to firms of changing prices.

Examples:

• Reprinting restaurant menus.
• Updating price tags at Walmart.
• Reprogramming systems.

High inflation → frequent price changes → wasted resources.

Shoe-Leather Costs

Costs of managing money when inflation erodes its value.

People:

• Hold less cash.
• Make more bank trips.
• Constantly move money between accounts.

Inflation makes holding money costly, so behavior changes in inefficient ways.

5. Loss of Purchasing Power and Moderate Inflation

Loss of Purchasing Power

If your salary stays at 70,000 dollars and inflation is 5%, your real income falls unless your wage increases too.

This is why we distinguish:

• Nominal values (current dollars)
• Real values (adjusted for inflation)

Why Moderate Inflation Isn’t Always Bad

Central banks like the Federal Reserve target about 2% inflation.

Low, stable inflation:

• Encourages spending today instead of delaying.
• Reduces risk of deflationary spirals.
• Avoids the instability of the 1970s and the collapse seen in the 1930s.

High and volatile inflation creates redistribution and uncertainty.
Deflation increases real debt burdens and can deepen recessions.