The firm must pay back __________ in one year. In one year, the lender must receive ________ to buy the same amount of goods that the $100 would be able to purchase today. The lender actually receives $110 in one year. The true gain to the lender is It is the ____________ rate of interest that ultimately matters to lenders/borrowers.
8/25/2010 16 Nominal and Real Interest Rates, 1970–2008 Costs of Inflation Many people believe that the major problem caused by inflation is that inflation lowers the purchasing power of a person’s income. This is not a true cost of inflation however. Why? The above, however, refers to average nominal wages. Some wages will rise by more than inflation, some by less, and some by the same amount. Inflation, then, causes changes in the The extent to which inflation redistributes income depends in part on whether the inflation is anticipated —in which case consumers, workers, and firms can see it coming and can prepare for it— or unanticipated —in which case they do not see it coming and do not prepare for it.
8/25/2010 17 The Problem with Anticipated Inflation If workers and firms both anticipate high inflation, they will be likely to agree to What is the problem with anticipated inflation then? There are costs associated with changing prices. These are called Low inflation means Another problem is that nominal returns are typically taxed instead of real returns, thus during high inflation Another Cost of Anticipated Inflation: Taxation of Interest Typically in the U.S., taxes are paid on nominal interest and nominal returns. When people buy bonds (or otherwise earn interest) they are When people buy bonds (or otherwise earn interest), they are concerned with the That is, the actual returns to bondholders involve adjusting the nominal interest for: The following example shows that bondholders are hurt by high inflation.