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reflect the interplay of the operation of free markets and the purposeful efforts of gov-
ernment to alter that distribution. Inflation interferes with and distorts this process.

But wait. Must inflation always rob lenders to bestow gifts upon borrowers? If both par-
ties see inflation coming, won™t lenders demand that borrowers pay a higher interest rate
as compensation for the coming inflation? Indeed they will. For this reason, economists
draw a sharp distinction between expected inflation and unexpected inflation.

The same is not true of Social Security benefits, which are automatically increased to compensate recipients for

changes in the price level.

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Chapter 6 121
The Goals of Macroeconomic Policy

What happens when inflation is fully expected by both parties? Suppose Diamond
Jim wants to borrow $1,000 from Scrooge for one year, and both agree that, in the
absence of inflation, a fair rate of interest would be 3 percent. This means that Dia-
mond Jim would pay back $1,030 at the end of the year for the privilege of having
$1,000 now.
If both men expect prices to increase by 6 percent, Scrooge may reason as follows: “If
Diamond Jim pays me back $1,030 one year from today, that money will buy less than
what $1,000 buys today. Thus, I™ll really be paying him to borrow from me! I™m no phi-
lanthropist. Why don™t I charge him 9 percent instead? Then he™ll pay back $1,090 at
the end of the year. With prices 6 percent higher, this will buy roughly what $1,030 is
worth today. So I™ll get the same 3 percent increase in purchasing power that we would
have agreed on in the absence of inflation and won™t be any worse off. That™s the least
I™ll accept.”
Diamond Jim may follow a similar chain of logic. “With no inflation, I was willing to
pay $1,030 one year from now for the privilege of having $1,000 today, and Scrooge was
willing to lend it. He™d be crazy to do the same with 6 percent inflation. He™ll want to
charge me more. How much should I pay? If I offer him $1,090 one year from now, that
will have roughly the same purchasing power as $1,030 today, so I won™t be any worse off.
That™s the most I™ll pay.”
This kind of thinking may lead Scrooge and Diamond Jim to write a contract with a
9 percent interest rate”3 percent as the increase in purchasing power that Diamond Jim
pays to Scrooge and 6 percent as compensation for expected inflation. Then, if the ex-
pected 6 percent inflation actually materializes, neither party will be made better or worse
off by inflation.
This example illustrates a general principle. The 3 percent increase in purchasing
power that Diamond Jim agrees to turn over to Scrooge is called the real rate of interest. The real rate of interest
is the percentage increase
The 9 percent contractual interest charge that Diamond Jim and Scrooge write into the
in purchasing power that
loan agreement is called the nominal rate of interest. The nominal rate of interest is calcu-
the borrower pays to the
lated by adding the expected rate of inflation to the real rate of interest. The general relation-
lender for the privilege of
ship is borrowing. It indicates the
increased ability to pur-
Nominal interest rate 5 Real interest rate 1 Expected inflation rate
chase goods and services
Expected inflation is added to compensate the lender for the loss of purchasing power that the lender earns.
that the lender expects to suffer as a result of inflation. Because of this,
The nominal rate of
Inflation that is accurately predicted need not redistribute income between borrowers interest is the percentage
by which the money the
and lenders. If the expected rate of inflation that is embodied in the nominal interest
borrower pays back exceeds
rate matches the actual rate of inflation, no one gains and no one loses. However, to the
the money that was bor-
extent that expectations prove incorrect, inflation will still redistribute income.9
rowed, making no adjust-
It need hardly be pointed out that errors in predicting the rate of inflation are the norm, ment for any decline in the
purchasing power of this
not the exception. Published forecasts bear witness to the fact that economists have great
money that results from
difficulty in predicting the rate of inflation. The task is no easier for businesses, con-
sumers, and banks. This is another reason why inflation is so widely condemned as unfair
and undesirable. It sets up a guessing game that no one likes.

So inflation imposes costs on society because it is difficult to predict. But other costs arise
even when inflation is predicted accurately. Many such costs stem from the fact that people
are simply unaccustomed to thinking in inflation-adjusted terms and so make errors in
thinking and calculation. Many laws and regulations that were designed for an inflation-
free economy malfunction when inflation is high. Here are some important examples.

Exercise: Who gains and who loses if the inflation turns out to be only 4 percent instead of the 6 percent that

Scrooge and Diamond Jim expected? What if the inflation rate is 8 percent?

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Part 2
122 The Macroeconomy: Aggregate Supply and Demand

Confusing Real and Nominal Interest Rates
People frequently confuse real and nominal interest rates. For example, most Americans
viewed the 12 percent mortgage interest rates that banks charged in 1980 as scandalously
high but saw the 61„2 percent mortgage rates of 2006 as great bargains. In truth, with infla-
tion around 21„2 percent in 2006 and 10 percent in 1980, the real interest rate in 2004 (about
4 percent) was well above the bargain-basement real rates in 1980 (about 2 percent).

The Malfunctioning Tax System
The tax system is probably the most important example of inflation illusion at work.
The law does not recognize the distinction between nominal and real interest rates; it
simply taxes nominal interest regardless of how much real interest it represents. Simi-
larly, capital gains”the difference between the price at which an investor sells an asset
A capital gain is the dif-
ference between the price and the price paid for it”are taxed in nominal, not real, terms. As a result, our tax sys-
at which an asset is sold tem can do strange things when inflation is high. An example will show why.
and the price at which it
Between 1984 and 2007, the price level roughly doubled. Consider some stock that was
was bought.
purchased for $20,000 in 1984 and sold for $35,000 in 2007. The investor actually lost pur-
chasing power while holding the stock because $20,000 of 1984 money could buy roughly
what $40,000 could buy in 2007. Yet because the law levies taxes on nominal capital gains,
with no correction for inflation, the investor would have been taxed on the $15,000 nomi-
nal capital gain”even though suffering a real capital loss of $5,000.
Many economists have proposed that this (presumably unintended) feature of the
law be changed by taxing only real capital gains, that is, capital gains in excess of infla-
tion. To date, Congress has not agreed. This little example illustrates a pervasive and
serious problem:
Because it fails to recognize the distinction between nominal and real capital gains, or
between nominal and real interest rates, our tax system levies high, and presumably un-
intended, tax rates on capital income when there is high inflation. Thus the laws that
govern our financial system can become counterproductive in an inflationary environ-
ment, causing problems that were never intended by legislators. Some economists feel
that the high tax rates caused by inflation discourage saving, lending, and investing”
and therefore retard economic growth.
Thus, failure to understand that high nominal interest rates can still be low real interest
rates has been known to make the tax code misfire, to impoverish savers, and to inhibit
borrowing and lending. And it is important to note that these costs of inflation are not purely
redistributive. Society as a whole loses when mutually beneficial transactions are prohib-
ited by dysfunctional legislation.
Why, then, do such harmful laws stay on the books? The main reason appears to be a
lack of understanding of the difference between real and nominal interest rates. People
fail to understand that it is normally the real rate of interest that matters in an economic
transaction because only that rate reveals how much borrowers pay and lenders receive in
terms of the goods and services that money can buy. They focus on the high nominal interest
rates caused by inflation, even when these rates correspond to low real interest rates.
The difference between real and nominal interest rates, and the fact that the real
rate matters economically whereas the nominal rate is often politically significant,
are matters that are of the utmost importance and yet are understood by very few
people”including many who make public policy decisions.

Another cost of inflation is that rapidly changing prices make it risky to enter into long-
term contracts. In an extremely severe inflation, the “long term” may be only a few days
from now. But even moderate inflations can have remarkable effects on long-term

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Chapter 6 123
The Goals of Macroeconomic Policy

loans. Suppose a corporation wants to borrow $1 million to finance the purchase of
some new equipment and needs the loan for 20 years. If inflation averages 2 percent
over this period, the $1 million it repays at the end of 20 years will be worth $672,971
in today™s purchasing power. But if inflation averages 5 percent instead, it will be
worth only $376,889.
Lending or borrowing for this long a period is obviously a big gamble. With the stakes
so high, the outcome may be that neither lenders nor borrowers want to get involved in
long-term contracts. But without long-term loans, business investment may become
impossible. The economy may stagnate.
Inflation also makes life difficult for the shopper. You probably have a group of stores
that you habitually patronize because they carry the items you want to buy at (roughly)
the prices you want to pay. This knowledge saves you a great deal of time and energy. But
when prices are changing rapidly, your list quickly becomes obsolete. You return to your
favorite clothing store to find that the price of jeans has risen drastically. Should you buy?
Should you shop around at other stores? Will they have also raised their prices? Business
firms have precisely the same problem with their suppliers. Rising prices force them to
shop around more, which imposes costs on the firms and, more generally, reduces the
efficiency of the entire economy.

The preceding litany of the costs of inflation alerts us to one very important fact: Pre-
dictable inflation is far less burdensome than unpredictable inflation. When is inflation
most predictable? When it proceeds year after year at a modest and more or less steady
rate. Thus, the variability of the inflation rate is a crucial factor. Inflation of 3 percent
per year for three consecutive years will exact lower social costs than inflation that is
2 percent in the first year, zero in the second year, and 7 percent in the third year. In
Steady inflation is more predictable than variable inflation and therefore has smaller
social and economic costs.
But the average level of inflation also matters. Partly because of the inflation illusions
mentioned earlier and partly because of the more rapid breakdown in normal customer
relationships that we have just mentioned, steady inflation of 6 percent per year is more
damaging than steady inflation of 3 percent per year.
Economists distinguish between low inflation, which is a modest economic problem,
and high inflation, which can be a devastating one, partly on the basis of the average
level of inflation and partly on its variability. If inflation remains steady and low, prices
may rise for a long time, but at a moderate and fairly constant pace, allowing people to
adapt. For example, inflation in the United States, as measured by the Consumer Price
Index, has been remarkably steady since 1991, never dropping below 1.6 percent nor
rising above 4.1 percent.
Very high inflations typically last for short periods of time and are often marked by
highly variable inflation rates from month to month or year to year. In recent decades, for
example, countries ranging from Argentina to Russia to Zimbabwe have experienced
bouts of inflation exceeding 100 percent or even 1,000 percent per year. (See “How to
Make Hyperinflation Even Worse” on the next page.) Each of these episodes severely dis-
rupted the affected country™s economy.
The German hyperinflation after World War I is perhaps the most famous episode of
runaway inflation. Between December 1922 and November 1923, when a hard-nosed
reform program finally broke the spiral, wholesale prices in Germany increased by
almost 100 million percent! But even this experience was dwarfed by the great Hungar-
ian inflation of 1945“1946, the greatest inflation of them all. For a period of one year,
the monthly rate of inflation averaged about 20,000 percent. In the final month, the price
level skyrocketed 42 quadrillion percent!

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Part 2
124 The Macroeconomy: Aggregate Supply and Demand

If you review the costs of inflation that have been discussed in this chapter, you will see
why the distinction between low and high inflation is so fundamental. Many economists
think we can live rather nicely in an environment of steady, low inflation. No one believes
we can survive very well under extremely high inflation. When inflation is steady and
low, the rate at which prices rise is relatively easy to predict. It can therefore be taken into
account in setting interest rates. Under high inflation, especially if prices are rising at ever-
increasing or highly variable rates, this is extremely difficult, and perhaps impossible, to
do. The potential redistributions become monumental, and lending and borrowing may
cease entirely.
Any inflation makes it difficult to write long-term contracts. Under low, creeping infla-
tion, the “long term” may be 20 years, or 10 years, or 5 years. By contrast, under high, gal-
loping inflation, the “long term” may be measured in days or weeks. Restaurant prices
may change daily. Airfares may go up while you are in flight. When it is impossible to en-
ter into contracts of any duration longer than a few days, economic activity becomes para-
lyzed. We conclude that
The horrors of hyperinflation are very real. But they are either absent in low, steady in-
flations or present in such muted forms that they can scarcely be considered horrors.

How to Make Hyperinflation Even Worse
For some years now, the world™s highest inflation rate has been in A newspaper story in July 2007 reported that “buying meat in
Zimbabwe these days is like buying an illegal substance.“* While the
the impoverished African country of Zimbabwe. And recently, it has
escalated into the first episode of virulent hyperinflation in government price ceiling for beef was Z$87,000 per kilogram, the
decades. article reported one of the few shopkeepers with meat to sell ask-
After averaging around 20 percent per year in the mid 1990s, ing Z$300,000 per kilo for the precious substance”while carefully
Zimbabwean inflation began to accelerate at the end of the 1990s watching the door for government inspectors. The local newspaper
and really took off starting in 2002. According to the International in one of Zimbabwe™s cities reported that trying to find beef for sale


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