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INFLATION PROBLEMS:

Two notable problems are associated with inflation--uncertainty and haphazard redistribution. Inflation, especially inflation that varies from month to month and year to year, makes long-term planning quite difficult. Prices, wages, taxes, interest rates, and other nominal values that enter into consumer, business, and government planning decisions can be significantly affected by inflation. Moreover, inflation tends to redistribute income and wealth in a haphazard manner--some people win and some people lose. This redistribution might not be that desired by society, failing to promote any of the basic economic goals of efficiency, equity, stability, growth, or full-employment.
Inflation of the price level is one of the more important macroeconomic issues facing economists and government leaders. The other macroeconomic issue with the same status is unemployment. Concerns over inflation have always existed in society, but they were most pronounced in the United States during the stagflation of the 1970s.

High and rising rates of inflation during the 1970s, reaching up to 14 percent, brought to the forefront the problems of inflation. The two key problems for society and the economy that are triggered by inflation are uncertainty and haphazard redistribution of income and wealth.

Uncertainty

Inflation creates uncertainty, especially when inflation is unexpected and catches people off guard or when it fluctuates widely from month to month or year to year. The reason that most people, consumers and producers alike, do not like inflation is that they are risk averse--they prefer a knowable, stable, predictable life. They would rather not have surprises, including unexpected inflation. A known, constant, or expected inflation can be easily integrated into the fabric of the economy. If someone KNOWS that prices will be increasing by 10 percent, then they can simply adjust plans accordingly. However, unexpected or changing inflation creates uncertainty and makes long-range planning exceedingly difficult.

For example, a significant amount of household, business, and government activity involves long-term commitments--such as:

  • Borrowing the funds used to purchase cars and homes.

  • Investing in multi-year capital construction projects.

  • Anticipating tax or revenue collections

  • Planning expenditure budgets.
Not knowing, or not correctly anticipating, inflation makes such commitments difficult and financially disastrous. Households and business can be forced into bankruptcy. Governments can encounter serious fiscal problems.
  • A worker who agrees to a multi-year employee contract with automatic wage increases anticipating a 2 percent inflation rate will have a falling living standard if the inflation rate ends up being 12 percent.

  • A business that implements the production of a new good expecting a 3 percent inflation-induced increase in material prices is likely to see few profits or large losses if the inflation rate is 13 percent.

  • A school district that borrows construction funds for 10 years at a 16 percent interest rate expecting a 10 percent inflation rate will be financially strapped over the ensuing decade if the inflation rate is only 5 percent.

Haphazard Redistribution

Inflation can haphazardly redistribute income and wealth in ways that society might not want. Of course, the redistribution of income and wealth has always been an inherent part of the economy. Society redistributes income from rich to poor, poor to rich, workers to nonworkers, or a host of other ways. For example, income generated by the owners of productive resource is has always been transferred to others with little or no ownership of productive resources (such as young, old, or disabled). However, inflation is likely to redistribute income according to its own criteria.

While inflation is an increase in the average price level, ALL prices do NOT increase at the same rate. When this happens, the owners of resource used in the production of goods with above average price increases also get relatively more income. Resource owners involved in the production of goods with below average price increases (even declining prices) get relatively less income. The end result is that income and wealth are redistributed from some resource owners to others.

  • Suppose, for example, that the overall inflation rate is 10 percent. However, health care prices rise by 20 percent while food prices do not change.

  • Labor and other resource owners in the health care industry end up with 20 percent more income that they can spend on production that is only 10 percent more expensive. Their real income, wealth, and living standards increase.

  • In contrast, labor and other resources in the food industry are forced to pay 10 percent higher prices, but they have the same amount of income. Their real income and wealth decreases.
The result is that income and wealth has been redistributed from food resources to health care resources.

One of the most noted areas of inflation-induced redistribution is between borrowers and lenders in the financial markets. When borrowers and lenders correctly anticipate inflation that transpires over the life of a loan, then they can set the interest rate to ensure that the purchasing power of the money loaned is equal to the purchasing power of the money repaid.

However, income and wealth are redistributed between borrowers and lenders when inflation is not correctly anticipated.

  • If inflation is more than expected, then the purchasing power of the repayment is less than the original loan, so income and wealth are redistributed from lenders to borrowers.

  • If inflation is less than expected, then the purchasing power of the repayment is more than the original loan, so income and wealth are redistributed from borrowers to lenders.
Suppose, for example, Duncan Thurly borrows $10,000 from a OmniBank to buy a car. In one year he will repay the bank $11,000, the $10,000 principal plus $1,000 in interest, which is based on a 10 percent interest rate. Duncan and the OmniBank agree to the terms of this loan, especially the 10 percent interest rate, based on expectations that the inflation rate will be zero.

What would happen, however, if the inflation rate ends up being 5 percent? Because inflation erodes the purchasing power of money, the $11,000 Duncan repays the bank is worth less with inflation that it would have been worth without. The bank is actually receiving only about $10,475 worth of purchasing power. Duncan, in contrast, is repaying this loan with money that is less valuable. He is only giving up $10,475 worth of goods and services by repaying the loan. The net result is that income and wealth have been effectively redistributed from the OmniBank to Duncan.

The redistribution, however, could go in the opposite direction. If Duncan and OmniBank came to the loan agreement expecting that the inflation rate would be 5 percent and it ended up being less, then income and wealth would have been redistributed from Duncan to OmniBank. The purchasing power of the money repaid would be greater than it need be.

<= INFLATION CAUSESINFLATION RATE =>


Recommended Citation:

INFLATION PROBLEMS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2014. [Accessed: July 29, 2014].


Check Out These Related Terms...

     | price level | price index | deflation | disinflation | inflation causes | inflation rate | Consumer Price Index | GDP price deflator | demand-pull inflation | cost-push inflation | unemployment problems |


Or For A Little Background...

     | inflation | business cycles | expansion | macroeconomics | macroeconomic goals | macroeconomic problems | production possibilities | gross domestic product | real gross domestic product | nominal gross domestic product |


And For Further Study...

     | cost of living | Producer Price Index | Wholesale Price Index | CPI and GDP price deflator | unemployment | Bureau of Labor Statistics | Bureau of Economic Analysis | National Income and Product Accounts | shortage | circular flow | stabilization policies | production cost | inflationary gap | inflationary expectations, aggregate demand determinant |


Related Websites (Will Open in New Window)...

     | Bureau of Economic Analysis | Bureau of Labor Statistics |


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