Download Inflation Costs

The Costs of Inflation
Why is inflation bad?
Obviously,
because
money
buys less
1
Cost of Inflation
THREE MISTAKES
2
Wages
People
believe
Wages and prices rise 1.and
fall together.
inflation decrease
real wages
If salaries rise @
the inflation rate,
real wages do
not change
Prices
Inflation does not decrease real wages.
3
The “Robbery Coefficient”
Increase in wages = Increase in productivity +
increase in prices (inflation)
Increase in productivity = 3%
Inflation = 2%
Increase in wages = 3+2 = 5%
4
3. Inflation is
blamed for
changes in
relative prices.
No Inflation
1 bag of apples = 1 gallon of gas
3 bags of apples =1 gallon of gas
Change in
Relative
Prices
The True Costs of Inflation
Why is inflation bad?
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A $1.20
increase in
75 years!
1938
Nominal Min Wage $0.25
CPI = 14.1
Real Min Wage = $1.77
2014
Nominal Min Wage $7.25
CPI = 238
Real Min Wage = $3
1. Inflation Costs: Arbitrary
Redistribution of Income
• Individuals whose incomes are fixed
(pensions) or grow slower than inflation
(minimum wage) lose purchasing power.
• Employers who enjoyed sale prices rising
faster than wages win…
Inflation
Arbitrary redistribution
of income from
minimum wage
workers
Arbitrary
redistribution of
to employers
income from retirees to
government, businesses
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5% Inflation = CPI increase by 5%
5% Inflation = Nominal value must
increase by 5%
CPI = 100
CPI = 100+ 100*0.05 =105
Today
$100
Full Basket
Future
(105)/(100)
Multiply by 1.05
=1.05
? = $105
$100(1.05)
Full Basket
Must protect yourself for Inflation!
CPI = 100
Today: you
lend $100
CPI =105
You need $105 to buy
a full basket
I return $100
Full Basket
95% Basket
To protect from inflation, charge
interest
If you lend $100 today at 10% interest
You get $100 + 100 (0.1) = 100 + 10 = $110.
$10 is your
reward for
postponing
consumption.
11
Interest Rate
The reward for those who
give up spending today in
order to spend tomorrow
The cost paid by those who
want/need to spend today
money they will make in the
future.
12
CPI = 100
Today: you
lend $100
CPI =105
Charge 10% interest
your reward for
postponing
consumption.
Full Basket
Full Basket
$105
Borrower
returns
$110
+ $5
CPI =105
CPI =110
CPI = 100
Today: you
lend $100
Full Basket
Charge 10% interest
The borrower is
happy. He used your
money for free!
Full Basket
$110
Borrower
returns
$110
+ $0
CPI =105
CPI =120
CPI = 100
The borrower
is
Charge
10% interest
Today:
veryyou
happy. He
lend
$100
returned
“less”
than he
borrowed!
Full Basket
90% of Basket
$120
Borrower
returns
$110
-
All I need to do
is charge the
correct
The
Real
Nominal rate!
Interest
All I need is to
be able to see
Rate
the future
inflation
Therate…
interest rate
written in a
contract between
lender and
10% borrower
-10%
10%
0%
Real Interest Rate = Nominal Interest Rate –
Inflation Rate.
10%
20%
0%
16
Year
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
Inflation
2
2.5
1
2.3
2.7
3.4
3?
What is your guess
for inflation in 2014?
Average=2.32
Guess Inflation = 3% Charge 7%
nominal interest
• If you guess right, and inflation is 3%, you
will make a 4% real return.
Nominal (7%) – Inflation (3%) = Real (4%)
• If you guess wrong and inflation is 5%, you
will make a 2% real return
Nominal (7%) – Inflation (5%) = Real (2%)
18
Year
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
Inflation
2
2.5
1
2.3
2.7
3.4
26!
Inflation
was 26%
Average=2.32
Guess Inflation = 3% Charge 7%
nominal interest
• If you are very wrong and inflation
is 26%, you will make a negative
return (you are giving money
away!)
Nominal (7%) – Inflation (26%) =
Real (-19%)
20
Year
What is your
1996
guess for
inflation
1997next
year (2006) if
1998
you
live in this
country?
1999
2000
2001
2002
2003
2004
2005
Index
156.9
160.5
163
166.6
172.2
177.1
179.9
184
188.9
195.3
Inflation
2.3
1.6
2.2
3.4
2.8
1.6
2.3
2.7
3.4
Year is your
What
guess for
1996
inflation next
1997
year (2006) if
1998
you
live in this
country?
1999
2000
2001
2002
2003
2004
2005
Index
100.52
101.05
101.98
100.79
99.85
98.78
124.33
141.05
147.28
161.48
Inflation
0.2
0.5
0.9
-1.2
-0.9
-1.1
25.9
13.4
4.4
9.6
U.S. Last 20 years
Between 1% and 6%
What is your
guess for
inflation next
year?
Between -2% and 6%
24
Venezuela
Between 10% and 120%
25
Between 5% and 30%
26
Between 3% and 35%
27
Your guess if
you live in this
country?
Between -10% and 50%
28
Ecuador
Between -5% and 50%
29
Guessing Inflation is not easy
When past inflation is high and
volatile: Argentina, Colombia,
Uruguay and Venezuela
30
Guessing Inflation is easier
When past inflation numbers are
low and stable : U.S.
31
Un-anticipated inflation hurts savers
Savings
Borrowers
Savers
Nominal Interest
Inflation higher than nominal interest
Real interest rate is negative
2. Costs of Inflation: Redistribution of
Income
High inflation is volatile and difficult to guess
• Lenders and savers lose
• Borrowers win
Inflation
Arbitrary redistribution of
income from lenders and
savers to borrowers
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Capital Gains
The difference between the selling price and the
purchase price of an asset resulting in a financial
profit for an investor.
– You purchased Google stock at $300/share in 2012
and sold it for $600 in 2014.
Capital Gain = 600 – 300 = $300
– You paid $800K for a house in 2011 and sold it for
1M in 2014.
Capital Gain = 1M – 800K = $200K
34
Interest Income
Interest received from an interest bearing asset:
– You made a $1,000 loan at 10% interest
– You saved $1,000 in an account that pays 10%
interest
– You bought a government bond that pays 10%
interest
– You bought a corporate bond that pays 10%
interest
Interest Income = 1,000 * 0.1= $100
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CPI = 100
CPI
CPI=105
=110
Charge 10% interest
Borrower
Today: you
returns
lend $100
Interest Income = $10
$110
Interest Tax (35%) = 0.35 *$10 = $3,50
Real Interest = $0
$5
Real Tax = $3,50/5 =0.7 a 70% tax!
Real Tax = $3,50 out of zero
Full Basket
Full
Full Basket
Basket $110
$105
Inflation increases taxes!
++$5
$0
CPI = 100
CPI
CPI=105
=110
Sell
Sellfor
for$110
$110
Today: you
Buy $100
Capital Gain = $10
stock
Capital Gains Tax (20%) = 0.2*$10 = $2
Real Capital Gain
Gain=
=$5
$0
Real Tax = $2/5 =0.4 a 40% tax!
Real Tax = $2 out of zero
Full Basket
Full
Full Basket
Basket $110
$105
Inflation increases taxes!
++$5
$0
3. Costs of Inflation
Inflation: The most unfair tax…
Due to Inflation, Capital gains
and interest income are unfairly
over-taxed.
38
Before
May 03
20%
< year
Reduced
to 0%
same
Tax
same as
ordinary
Income
15%
15%
higher
>
20%
39
If you earn
$400,000 working
you pay 39.6% in
taxes
If you earn
$400,000 selling
stock you pay
20% in taxes
40
The struggle with the administration
over increasing taxes on capital gains.
“ It’s a war,
It’s like when Hitler invaded Poland in
1939.”
Stephen Schwartzman, chairman and cofounder
of the Blackstone Group, one of the world’s
largest private-equity firms.
41
Who suffers from inflation?
• People on fixed incomes & Min wage workers
(wages/pensions are not fully adjusted by
inflation)
• The poor (government transfers to the poor are
not adjusted by inflation).
• Lenders who guess inflation wrong.
• Individuals whose incomes come mainly from
capital gains and interest income.
Inflation does no special harm to the poor
• During inflationary periods the prices paid by
the poor rise neither faster nor slower than
the prices paid by the rest of us.
– Inflation does not raise the incomes of the rich
relative to those of the poor.
• The opposite is true: Real incomes at the
bottom rise relative to those at the top
– Making income distribution slightly more equal.
43
Overall
Teens
Black or African
American
Hispanic
Men
Women
White
5/23/2017
Worst
10
27
2015
5.5
17
16.8
13.1
10.4
8.4
9
10.4
6.6
5.2
4.9
4.7
44
1% Unemployment = 2.5% of GDP
GDP*0.025 = Goods and Services lost for
each 1% extra unemployment
14,000B *0.025 = 350B lost for
each 1% extra unemployment
45
Okun’s Law: an example
2007 Ur = 5%
GDP= 12T
2008 Ur = 9%
Extra Unemployment = 9– 5= 4%
For each 1% extra unemployment we lose
2.5% of GDP:
% Lost GDP = 4(2.5) = 10%
Lost GDP = 12T (0.10)= 1.2T
Production lost that can not be recovered.
Majority of
those who are
unemployed find
jobs in less than
5 weeks
5/23/2017
(c) 2002 Claudia Garcia-Szekely
47
Majority of
those who are
unemployed find
jobs in less than
5 weeks
5/23/2017
Majority of those
who are unemployed
are unemployed for
more than 6 months
(c) 2002 Claudia Garcia-Szekely
48
VIDEO
5/23/2017
(c) 2002 Claudia Garcia-Szekely
49
The Phillips Curve
If we plot past data Years of High
on Inflation and Inflation
unemployment
we observe:
There is a temporary
trade off between
Years of Low
inflation and
Inflation
unemployment
Years of Low
High
Unemployment Unemployment
Unemployment
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The trade off between
unemployment and inflation
To reduce inflation by 1%, we must
increase unemployment above the
natural rate by 2%
51
Inflation
Unemployment
10%
The trade off between unemployment
and inflation
A reduction in inflation from 10% to 4% (6%)
costs (6x2) 12% in terms of extra
unemployment…
Paul Volcker: Chairman of the Federal
Reserve under Jimmy Carter and Ronald
Reagan (from August 1979 to August
1987)
53
Unemployment above the NRU
(5.8%)
1980: 1.3 points
1981: 1.8 points
1982: 3.9 points
1983: 3.8 points
1984: 1.7 points
Total: 12.5 points
Between 1980 and
1985 a 6%
reduction in
inflation cost
unemployment to
be 12.5% points
above the natural
rate.
54
True or False?
1. Inflation is a serious problem because inflation causes
real wages to decline.
2. Changes in relative prices usually lead to increases in
real income because prices have changed.
3. Un-anticipated inflation tends to redistribute real
income from lenders to borrowers.
4. Inflation is a very minor problem for lenders because
it is relatively easy to estimate future rates of
inflation.
5. The incentive to lend increases as the real rate of
interest decreases.
6. Low inflation rates tend to accelerate into higher and
higher rates of inflation.
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Practice
1. You agree to lend Claudia $1,000 for one
year. The interest on the loan is 5%. If at the
end of the year prices have increased by 7%,
in real terms, who won and who lost? Why?
2. If you want to increase your purchasing
power by 5% by lending money and you
expect inflation to be 3% during the life of
the loan, what interest rate should you
charge on that loan?
56
3. The CPI today is 100 you expect the CPI to be
97 tomorrow. If you borrow $100 today at
5%. Will the change in prices help you or hurt
you in real terms? Why?
4. Explain how the current U.S. tax system
levies taxes on capital gains and earned
interest. What does this mean for the costs
of inflation?
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