>>Inflation, Disinflation, and DeflationSection 2: Effects of Inflationchapter16We’ve seen how the use of the printing press to cover a government deficit leads toinflation. And we’ve also learned how a government’s attempt to collect a large realinflation 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 thecost 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 theeconomy—as well as the prices paid by consumers. In fact, recall from the AS-ADmodel that when an increase in the money supply leads to a rise in the aggregate pricelevel, in the long run real GDP and aggregate real income are unchanged.Although it is incorrect that inflation makes everyone worse off, inflation doeshave important effects on the economy that are not fully captured by the AS–ADmodel. We’ll soon learn that unexpected inflation, although leaving real GDP and
2C H A P T E R 1 6S E C T I O N 2 : E F F E C T S O F I N F L AT I O Ntotal real income unchanged, hurts some people while helping others. Then we’ll seethat anticipated inflation can indeed impose real costs on the economy; if sufficientlyhigh, it can reduce real GDP and real incomes.Winners and Losers from Unexpected InflationInflation can hurt some people while helping others for one main reason: contractsthat extend over a period of time, such as loans, are normally specified in nominalterms. In the case of a loan, the borrower receives a certain amount of funds at thebeginning, and the loan contract specifies how much he or she must repay at somefuture date. The real burden of that repayment to the borrower depends greatly on therate of inflation over the intervening years of the loan because the inflation rate overthe 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 hadexpected, and lenders will receive payment with a lower real value than they had expected.Conversely, if the inflation rate is lowerthan expected, borrowers will repay their loanswith funds that have a higher real value than they had expected, and lenders will receivepayment with a higher real value than they had expected. So when inflation exceeds oris lower than expectations, either the borrower (in the case of higher-than-expectedinflation) or the lender (in the case of lower-than-expected inflation) benefits from thesurprise, at the other party’s expense. But if the actual inflation rate is equal to theanticipated rate, inflation does not create winners or losers in loan contracts.