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

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.

• 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

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.

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.

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.