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Economics 1022B inflation and unemployment

5 real rate is still 10 inflation increases nominal

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Unformatted text preview: real rate is still 10% • Inflation increases nominal interest rates Inflation and Interest Rates Rates Effects of Inflation Effects Unanticipated Inflation in the Capital Market • Redistribution of income – If inflation is higher than expected, borrowers gain – If inflation is lower than expected, lenders gain • Too much or too little borrowing Effects of Inflation Effects • A bank wants a real interest rate of 5%, if expected inflation is 3% they will charge 8% • But, if inflation turns out to be 4%, then the real rate is 4% • Or, if inflation turns out to be 2%, then the real rate is 6% Anticipated Inflation Anticipated • If people correctly anticipate increases in aggregate demand, they will adjust wage rates to keep up with inflation. • Inflation proceeds with real GDP equal to potential GDP, and unemployment equal to the natural rate. Price level (GDP deflator, 1997 = 100) Anticipated Inflation LAS 133 121 SAS2 SAS SAS1 SAS0 110 AD2 AD0 0 AD1 700 750 800 850 900 950 Real GDP (billions of 1997 dollars) Anticipated Anticipated increases increases in AD bring in AD inflation inflation but no change but in real GDP in The Costs of Anticipated Inflation Inflation • Transaction costs (“boot leather costs”) – Due to increased velocity of circulation • Tax effects – Inflation increases interest rates, so increases tax on interest income Example: Nominal interest rate = 6% Inflation = 4% Real interest rate = 2% Tax rate = 50% After-tax nomina...
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