Inflation

We have already discussed GDP and unemployment. Our third headline number of economic measurement is inflation.

Many stories in the popular media focus on changes in prices of specific goods, such as gasoline or food. Looking at the price of a single type of good is about relative prices, and many of these changes are the result of shifts in supply or demand in a specific product market. Poor weather in Brazil may cause the supply of Arabica coffee beans to decline. That will make the price of coffee in the United States go up. If the price of energy drinks stays the same, then demand for energy drinks will rise. That makes the price of energy drinks go up.

In the entire economy such changes happen to products frequently. As an example, in 1955 a McDonald’s hamburger cost $0.15. In 2020, that price was $2.19, an increase of 1360%. That comes out to nearly a 21% increase per year.

Although we can talk about price changes of individual goods, in macroeconomics we are primarily concerned with the overall price level.

Introductory terms and concepts

Formally, here are some key terms around inflation.

Definitions

Inflation

A general increase in the price level.

Disinflation

A lowering of the rate of inflation.

Deflation

A general decrease in the price level. Uncommonly referred to as negative inflation.

Hyperinflation

A very high rate of inflation that leads to a drastic loss in purchasing power in a relatively short period of time.

Inflation only refers to a general rise in the price level. We can view the overall price level as being linked to the real value of money, since it represents how much money can buy in terms of actual goods and services.

Thinking along these lines, rising prices mean that each dollar buys fewer goods and services, so inflation can also be viewed as a decline in the purchasing power of money or as a tax on holding cash. Thus positive inflation incentivizes spending and investment over holding cash.

Disinflation, is a lowering of the rate of inflation. Put another way, a slowing of the rate of inflation. This is often desirable if there is a shock that makes prices go up, as it returns the economy to stability.

If the general price level falls, that is called deflation. Deflation is undesirable because of the impact it has on decision-making. If the price level is expected to be lower for multiple periods, that incentivizes the postponing of economic activities. Consumers will wait for many purchases as they can to benefit from lower prices. Firms will not desire to invest, because money today is worth more than money in the future.

This postponement of activity leads to further price decreases, as firms try to incentivize consumers to make purchases. This process of initial price decreases leading to further price decreases is called a deflationary spiral.

On the other end of the spectrum is hyperinflation, which lacks a commonly agreed upon definition. Economist Philip Cagan, who in the 1950s completed the first academic study of historical episodes of hyperinflation, defined it as inflation over 50% a month. That equates to nearly 13,000% inflation in a year due to compounding.

Looser definitions look for specific economic outcomes. Those include significant printing of currency and currency substitution, widespread use of a more stable currency or real asset (such as gold or silver).

The most cited example is usually the Weimar Republic from 1920 to 1923. Bread that cost 160 marks in 1922 cost 200 billion marks at the end of 1923. The peak monthly inflation was 29,525% in November of 1923, equivalent to 20.9% a day. In that situation, all a regular consumer can do is to spent their paycheck as quickly as possible. Whatever is not used for current goods and services will be used to buy items that can serve as a store of value.

Because of the problems caused by deflation and hyperinflation, small amounts of positive inflation are usually considered to be the most desirable outcome for an economy. This will be covered more later, for now keep in mind that many countries have a yearly inflation target of 2%.

Costs of inflation

There are three intuitive stories that can explain the costs of inflation.

• Menu costs

  • Real costs of changing prices, such as printing menus or changing price tags.

• Shoe-leather costs

  • Consumers make more trips to the bank and spend more time managing money. This is to earn more interest and avoid the loss of purchasing power from holding cash.

• Unit of account costs - Losses due to a higher level difficulty of making comparisons and negotiating contracts.

Differences in expected and unexpected inflation

Inflation has different effects, depending on whether the inflation is expected or unexpected. If inflation is expected, then it can be planned for. Expected inflation is included when workers negotiate wages, when banks set interest rates, and when firms set long-term contracts. Unexpected inflation creates winners and losers, because it was not planned for.

The Fisher equation provides us a connection between nominal interest rates and real interest rates. Interest rates also reflect returns on funds, for example savings accounts or investments, so that we may also talk about nominal returns and real returns.

$$\begin{array}{rl}& \text{Nominal interest rate }=\text{ Real interest rate }+\text{ Inflation}\end{array}$$

Inflation can always be separated into expected inflation and unexpected inflation. This leads to two ways of understanding this relationship, a forward-looking version that focuses on expected inflation and a backward-looking version that focuses on unexpected inflation.

Forward-looking Fisher equation

$$\begin{array}{rl}& \text{Nominal interest rate }=\text{ Real interest rate }+\text{Expected Inflation}\end{array}$$

In the forward-looking Fisher equation we take real returns as fixed and assume that unexpected inflation is zero. Thus any inflation that is expected, is already included in nominal interest rates. So an increase in expected inflation leads to a rise in nominal interest rates and increased nominal returns without changing real returns.

We call this the forward-looking version because this change will only affect new agreements after expectations have changed, it does not affect any old contracts or past returns.

Backward-looking Fisher equation

In contrast, with unexpected inflation nominal contracts were chosen based on the “wrong” value. This creates winners and losers. It may be helpful to note that specifically with inflation, if one side of a deal has a financial gain, the other side must have a financial loss.

Imagine you made a loan to a friend of $100, at a 10% interest rate. You expect inflation to be 2%, but it ends up being 5% instead. Take a moment to consider who would be happy with this outcome, you or your friend?

We can assess a situation such as the one in the example by using a backward-looking return version of the Fisher equation. Because we already have a financial transaction or contract, the nominal interest rate is fixed. In the Fisher equation, combine it with expected inflation and rearrange as follows,

$$\begin{array}{rl}\text{Realized real interest rate }& =\text{Nominal interest rate }-\text{ Expected inflation}-\text{ Unexpected inflation}\\ \text{Realized real interest rate }& =\text{Expected real interest rate}-\text{ Unexpected inflation}.\end{array}$$

Any inflation that is unexpected reduces real returns.

Calculations using either version of the Fisher equation are fair game. Going back to our loan to a friend, the nominal rate of 10% gives an expected real return of $10-2=8$. The unexpectedly high inflation rate gives a realized real return of $10-5=5$. With higher than expected inflation it was beneficial to have borrowed, and was detrimental to have been a lender.

Winners and losers summarized

If inflation is higher than expected, real returns are lower than planned. Another way to view this is that money used for payments is worth less than anticipated. If inflation is lower than expected, real returns are higher than planned. Alternatively, repayments are worth more than anticipated.

That logic leads to the following summary of groups that gain from unexpected inflation and groups that lose with unexpected inflation.

Group	Gain?	Lose?
Borrowers	[x]
Lenders		[x]
Anyone with fixed payments		[x]
Anyone with flexible payments	[x]
Businesses with fixed costs	[x]
Savers		[x]

One way to view this table, is that anyone who would prefer a higher interest rate is harmed by unexpected inflation and anyone who would prefer a lower interest rate benefits from it.

As a final example, imagine Joe’s Coffee House, a company that signs a multi-year contract for coffee beans. This has a fixed nominal increase in price, which is set with a specific expected inflation rate in mind. The coffee shop benefits if the inflation rate is higher than expected and the coffee wholesaler loses. This is because Joe’s Coffee House ends up with a lower than anticipated real interest rate for their price increases, and consequently the wholesaler receives a lower rate.