KW_Macro_Ch_16_Sec_02_Effects_of_Inflation

KW_Macro_Ch_16_Sec_02_Effects_of_Inflation - chapter 16...

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>> Inflation, Disinflation, and Deflation Section 2: Effects of Inflation chapter 16 We’ve seen how the use of the printing press to cover a government deficit leads to inflation. And we’ve also learned how a government’s attempt to collect a large real inflation tax can lead to fiscal disaster. But even in the absence of such a disaster, inflation can have important consequences. Recall the widespread belief that inflation makes everyone worse off by raising the cost of living. As we discussed earlier, this is a fallacy. It misses the point that infla- tion raises the prices received by firms—which in turn determine incomes paid in the economy—as well as the prices paid by consumers. In fact, recall from the AS-AD model that when an increase in the money supply leads to a rise in the aggregate price level, in the long run real GDP and aggregate real income are unchanged. Although it is incorrect that inflation makes everyone worse off, inflation does have important effects on the economy that are not fully captured by the AS–AD model. We’ll soon learn that unexpected inflation, although leaving real GDP and
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2 CHAPTER 16 SECTION 2: EFFECTS OF INFLATION total real income unchanged, hurts some people while helping others. Then we’ll see that anticipated inflation can indeed impose real costs on the economy; if sufficiently high, it can reduce real GDP and real incomes. Winners and Losers from Unexpected Inflation Inflation can hurt some people while helping others for one main reason: contracts that extend over a period of time, such as loans, are normally specified in nominal terms. In the case of a loan, the borrower receives a certain amount of funds at the beginning, and the loan contract specifies how much he or she must repay at some future date. The real burden of that repayment to the borrower depends greatly on the rate of inflation over the intervening years of the loan because the inflation rate over the life of the loan determines how large the repayment is in real terms. When a borrower and a lender enter into a loan contract, each party has an expec- tation about the future rate of inflation. If the inflation rate is higher than expected, borrowers will repay their loans with funds that have a lower real value than they had expected, and lenders will receive payment with a lower real value than they had expected. Conversely, if the inflation rate is lower than expected, borrowers will repay their loans with funds that have a higher real value than they had expected, and lenders will receive payment with a higher real value than they had expected. So when inflation exceeds or is lower than expectations, either the borrower (in the case of higher-than-expected inflation) or the lender (in the case of lower-than-expected inflation) benefits from the surprise, at the other party’s expense. But if the actual inflation rate is equal to the anticipated rate, inflation does not create winners or losers in loan contracts. To make this point concrete, we need to recall the distinction between the
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KW_Macro_Ch_16_Sec_02_Effects_of_Inflation - chapter 16...

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