Inflation erodes the purchasing power of money, and when it is unanticipated it moves purchasing power from some people to others. Set the inflation rate people expected and the rate that actually happened, then watch who gains, who loses, and who is protected. Even fully anticipated inflation has costs, and the lab tracks those too.
Everyone made plans a year ago using the expected inflation rate. Loans were signed at a nominal rate of 3% plus expected inflation. Then actual inflation arrived.
Most bars compare the result with the plan the person made using expected inflation. The retiree and cash saver bars compare with stable prices, because a fixed pension and cash lose purchasing power to any inflation, expected or not.
When the price level rises, each dollar buys fewer goods and services. Cash and any income fixed in dollars, such as a pension with no cost-of-living adjustment, lose purchasing power whether or not the inflation was expected.
Anticipated inflation can be built into nominal interest rates and wage contracts, so it causes little redistribution. Unanticipated inflation catches people locked into contracts at the wrong rate, and purchasing power moves from one side of the contract to the other.
A fixed nominal rate includes the inflation lenders expected. If actual inflation is higher, the real rate falls: borrowers repay with dollars that buy less, so borrowers gain and lenders lose. If inflation is lower than expected, or prices fall, the reverse happens.
Real income is what your income can buy. A worker whose raise was fixed using expected inflation loses real income when inflation comes in higher, and the employer gains. A cost-of-living adjustment (COLA) raises pay with the price index and protects the real wage.
Shoe-leather costs are the time and effort people spend holding less cash, such as extra trips to the bank. Menu costs are the real costs firms pay to change listed prices, such as reprinting menus and price tags. Both grow as inflation rises.
Money is the unit we measure value in. Inflation makes that measure less reliable, which distorts decisions. Taxes are a key example: people can pay tax on nominal gains that are not real gains. In hyperinflation all of these costs become severe.
Memorize the middle column. To get the last column, flip every result.
| Person or group | Why they are exposed | Inflation higher than expected | Inflation lower than expected (or deflation) |
|---|---|---|---|
| Borrower with a fixed-rate loan | Repays a fixed number of dollars | Gains: repays with dollars that buy less | Loses: real burden of the debt rises |
| Lender or bank with fixed-rate loans | Receives a fixed number of dollars | Loses: real interest rate earned is lower than planned | Gains |
| Retiree on a fixed pension (no COLA) | Income fixed in dollars | Loses purchasing power | Gains if prices fall; loses less if inflation is just lower |
| Worker with a multi-year fixed wage contract | Raise set using expected inflation | Loses: real wage below plan | Gains: real wage above plan |
| Employer paying fixed wages | Pays a fixed number of dollars | Gains: real labor cost falls | Loses |
| Saver holding cash | Cash pays 0% nominal interest | Loses purchasing power | Gains if prices fall |
| Worker with a COLA | Pay rises with the price index | Protected | Protected |
| Borrower or lender with a variable-rate loan | Rate resets with inflation | Protected | Protected |
AP-style multiple choice. Pick an answer to see the explanation.
The vocabulary for topic 2.5. Read the list, flip through flashcards, or quiz yourself. For every term in the unit, see the Unit 2 terminology guide.