Unanticipated inflation π π e a realized real

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Economics: Private and Public Choice
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Chapter 13 / Exercise 12
Economics: Private and Public Choice
Gwartney/Stroup/Sobel/Macpherson
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2.Unanticipated inflation (ππe)
e
π
π
4%
e
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Economics: Private and Public Choice
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Chapter 13 / Exercise 12
Economics: Private and Public Choice
Gwartney/Stroup/Sobel/Macpherson
Expert Verified
12Abel/Bernanke/Croushore •Macroeconomics, Sixth Edition(2)From borrowers to lenders when π<πeData ApplicationSince the inflation of the mid-1970 was a surprise to people, it led to a large transfer of wealth. The biggest winners in the 1970s were homeowners who owned land (which appreciated in value with inflation) and had fixed-rate mortgages (whose value fell with inflation). The biggest losers were the wealthy who owned stocks and bonds, as real returns fell dramatically because of inflation.d.So people want to avoid risk of unanticipated inflation(1)They spend resources to forecast inflationData ApplicationIn my article, “Inflation Forecasts: How Good Are They?” (Federal Reserve Bank of Philadelphia Business Review, May/June 1996), I examine tests of bias in the inflation forecasts of both consumers and professional forecasters. The forecasts looked very bad in the 1970s, probably because of the two big oil price shocks in that period. Since then, the forecasts have been very good, suggesting that the forecasts are formed rationally.(2)Box 12.2: Indexed contracts(a)People could use indexed contracts to avoid the risk of transferring wealth because of unanticipated inflation(b)Most U.S. financial contracts are not indexed, with the exception of some long-term contracts like adjustable-rate mortgages and inflation-indexed bondsissued by the U.S. Treasury beginning in 1997(c)Many U.S. labor contracts are indexed by COLAs (cost-of-living adjustments)(d)Indexed contracts are more prevalent in countries with high inflationPolicy ApplicationIt’s difficult to figure out how to index wages to inflation, or how low inflation should be, when inflation isn’t measured very well. For an interesting discussion of the issues and implications of mismeasurement of inflation, see the symposium on “Measuring the CPI” in the Journal of Economic Perspectives,Winter 1998.e.Loss of valuable signals provided by prices(1)Confusion over changes in aggregate prices vs. changes in relative prices(2)People expend resources to extract correct signals from prices
Chapter 12Unemployment and Inflation 13Data ApplicationFor a review of the empirical evidence on the costs of inflation, see the article by John Driffill, Grayham E. Mizon, and Alistair Ulph, “Costs of Inflation,” in B. M. Friedman and F. H. Hahn, eds., Handbook of Monetary Economics, vol. II, Amsterdam: Elsevier Science Publishers, 1990, pp. 1013–1066.3.The costs of hyperinflationa.Hyperinflation is a very high, sustained inflation (for example, 50% or more per month)(1)Hungary in August 1945 had inflation of 19,800% per month(2)Bolivia had annual rates of inflation of 1281% in 1984, 11,750% in 1985, 276%in 1986Data Application

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