One cost of inflation is that it often redistributes purchasing power within society. But because the winners and losers are chosen haphazardly—rather than by conscious social policy—the redistribution of purchasing power is not generally desirable. In some cases, the shift in purchasing power is downright perverse—harming the needy and helping those who are already well off.
How does inflation sometimes redistribute real income? An increase in the price level reduces the purchasing power of any payment that is specified in nominal terms. For example, some workers have contracts that set their nominal wage for two or three years, regardless of any future inflation. The nationally set minimum wage, too, is set for several years and specified in nominal dollars. Under these circumstances, inflation can harm ordinary workers, since it erodes the purchasing power of their pre-specified nominal wage. Real income is redistributed from these workers to their employers, who benefit by paying a lower real wage. But the effect can also work the other way: benefiting ordinary households and harming businesses. For example, many homeowners sign fixed-dollar mortgage agreements with a bank. These are promises to pay the bank the same nominal sum each month. Inflation can reduce the real value of these payments, thus redistributing purchasing power away from the bank and toward the average homeowner.
In general, inflation can shift purchasing power away from those who are awaiting future payments specified in dollars, and toward those who are obligated to make such payments.
But does inflation always redistribute income from one party in a contract to another? Actually, no; if the inflation is expected by both parties, it should not redistribute income. The next section explains why.
Expected Inflation Need Not Shift Purchasing Power. Suppose a labor union is negotiating a three-year contract with an employer, and both sides agree that each year, workers should get a 3-percent increase in their real wage. Labor contracts, like most other contracts, are usually specified in nominal terms: The firm will agree to give workers so many additional dollars per hour each year. If neither side anticipates any inflation, they should simply negotiate a 3-percent nominal wage hike. With an unchanged price level, the real wage would then also rise by the desired 3 percent.
But suppose instead that both sides anticipate 10-percent inflation each year for the next three years. Then, they must agree to more than a 3-percent nominal wage increase in order to raise the real wage by 3 percent. How much more?
We can answer this question with a simple mathematical rule:
Over any period, the percentage change in a real value (%AReal) is approximately equal to the percentage change in the associated nominal value (%ANominal) minus the rate of inflation:
%AReal = %ANominal - Rate of inflation.
If the inflation rate is 10 percent, and the real wage is to rise by 3 percent, then the change in the nominal wage must satisfy the equation
3 percent = %ANominal — 10 percent =>- %ANominal = 13 percent.
You can see that as long as both sides correctly anticipate the inflation, and no one stops them from negotiating a 13-percent nominal wage hike, inflation will not affect either party in real terms:
If inflation is fully anticipated, and if both parties take it into account, then inflation will not redistribute purchasing power.
We come to a similar conclusion about contracts between lenders and borrowers. When you lend someone money, you receive a reward—an interest payment— for letting that person use your money instead of spending it yourself. The annual interest rate is the interest payment divided by the amount of money you have lent. For example, if you lend someone $1,000 and receive back $1,040 one year later, then your interest payment is $40, and the interest rate on the loan is $40/$1,000 = 0.04, or 4 percent.
But there are actually two interest rates associated with every loan. One is the nominal interest rate—the percentage increase in the lender's dollars from making the loan. The other is the real interest rate—the percentage increase in the lender's purchasing power from making the loan. It is the real rate—the change in purchasing power—that lenders and borrowers should care about.
In the absence of inflation, real and nominal interest rates would always be equal. A 4-percent increase in the lender's dollars would always imply a 4-percent increase in her purchasing power. But if there is inflation, it will reduce the purchasing power of the money paid back. Does this mean that inflation redistributes purchasing power? Not if the inflation is correctly anticipated, and if there are no restrictions on making loan contracts.
For example, suppose both parties anticipate inflation of 5 percent and want to arrange a contract whereby the lender will be paid a 4-percent real interest rate. What nominal interest rate should they choose? Since an interest rate is the percentage change in the lender's funds, we can use our approximation rule,
Nominal interest rate The annual percent increase in a lender's dollars from making a loan.
Real interest rate The annual percent increase in a lender's purchasing power from making a loan.
%AReal = %ANominal - Rate of inflation which here becomes %A in Lender's purchasing power = %A in Lender's dollars - Rate of inflation or
Real interest rate = Nominal interest rate - Rate of inflation.
In our example, where we want the real interest rate to equal 4 percent when the inflation rate is 5 percent, we must have
4 percent = Nominal interest rate — 5 percent or
Nominal interest rate = 9 percent.
Once again, we see that as long as both parties correctly anticipate the inflation rate, and face no restrictions on contracts (that is, they are free to set the nominal interest rate at 9 percent), then no one gains or loses.
When inflation is not correctly anticipated, however, our conclusion is very different.
Unexpected Inflation Does Shift Purchasing Power. Suppose that, expecting no inflation, you agree to lend money at a 4-percent nominal interest rate for one year. You and the borrower think that this will translate into a 4-percent real rate. But it turns out you are both wrong: The price level actually rises by 3 percent, so the real interest rate ends up being 4% — 3% = 1%. As a lender, you have given up the use of your money for the year, expecting to be rewarded with a 4-percent increase in purchasing power. But you get only a 1-percent increase. Your borrower was willing to pay 4 percent in purchasing power, but ends up paying only 1 percent. Unexpected inflation has led to a better deal for your borrower and a worse deal for you.
That will not make you happy. But it could be even worse. Suppose the inflation rate is higher—say, 6 percent. Then your real interest rate ends up at 4% — 6% = —2%—a negative real interest rate. You get back less in purchasing power than you lend out—paying (in purchasing power) for the privilege of lending out your money. The borrower is rewarded (in purchasing power) for borrowing!
Negative real interest rates like this are not just a theoretical possibility. In the late 1970s, when inflation turned out to be higher than expected for several years in a row, many borrowers ending up paying negative rates to lenders.
Now, let's consider one more possibility: Expected inflation is 6 percent, so you negotiate a 10-percent nominal rate, thinking this will translate to a 4 percent real rate. But the actual inflation rate turns out to be zero, so the real interest rate is 10 percent — 0 percent = 10 percent. In this case, inflation turns out to be less than expected, so the real interest rate is higher than either of you anticipated. The borrower is harmed, and you (the lender) benefit.
These examples apply, more generally, to any agreement on future payments: to a worker waiting for a wage payment and the employer who has promised to pay it; to a doctor who has sent out a bill and the patient who has not yet paid it; or to a supplier who has delivered goods and his customer who hasn't yet paid for them.
When inflationary expectations are inaccurate, purchasing power is shifted between those obliged to make future payments and those waiting to be paid. An inflation rate higher than expected harms those awaiting payment and benefits the payers; an inflation rate lower than expected harms the payers and benefits those awaiting payment.
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