Holt 7525-9 S15_IT

If the price level increases at a high rate year after year, this is continued inflation. Continued
inflation could be caused by continued decreases in SRAS. But this is highly unlikely. Continued
inflation is almost always caused by continued increases in AD. Continued increases in AD are
caused by continued increases in the money supply. Whenever we see a country suffering from
continued inflation, we can be confident of the source of the problem; a rapidly increasing money
supply. For a discussion of why a less developed country might pursue a policy of a rapidly
increasing money supply, see the appendix on seignorage at the end of the chapter.
Effects of Inflation
Potentially, inflation could have no practical effect.
Example 13: The castaways on Gilligan’s Island are using Monopoly money as their medium of
exchange. Gilligan finds another Monopoly game and the new money is issued to everyone in
proportion to their current money holdings. As a result of this doubling of the money supply,
prices will double. But everyone will have twice as much money to spend. No one is better off or
worse off because of the inflation.
Realistically, inflation usually does have effects. Some will gain from inflation and others will lose.
The overall economy may be affected. Among the effects of inflation are:
1. Inflation decreases the buying power of people who hold money. This effect is minor as
long as the rate of inflation is low and people don’t hold money for very long. But if a person
holds money for an extended period of time or when the inflation rate is high, that person will
lose significant buying power.
Example 14: Karen receives $5,000 as a graduation present. One month later, she spends the
money. If the annual rate of inflation is 3%, Karen will have lost .25% of her buying power ($12.50
in this case) because of the inflation. What if Karen had received the $5,000 in 1990 (when the
CPI was 130.7), and then held the money until 2013 (when the CPI was 233.0)? In 2013, Karen
spends the money. She will have lost about 42% of her buying power ($2,195 in this case)
because of the inflation.
2. Inflation reduces the real interest rate earned on savings. The real interest rate is equal to
the nominal interest rate minus the rate of inflation.
Example 15A: In Year 1, Arlene invests $10,000 in a one-year corporate bond which pays a 5%
interest rate. At the end of one year, Arlene receives $10,500 ($10,000 principal plus $500
interest). The rate of inflation for the year is 3%. Arlene’s real interest rate is 2%, as computed
below;
Real interest rate = Nominal interest rate – Inflation rate = 5% – 3% = 2%
3. Increasing inflation benefits borrowers and hurts lenders. The interest rate agreed to
between a borrower and a lender will reflect their expectations of the future rate of inflation. If
the rate of inflation increases, the borrower will benefit because the real rate of interest that
the borrower is paying will be lower than expected. Likewise, the lender will suffer because the
increase in inflation will lower the real interest rate the lender is earning on the loan.
Example 15B: In Year 2, Arlene lends $10,000 to Professor at an interest rate of 10%. Arlene is
expecting the rate of inflation to be 3%, giving her a real interest rate of 7%. The rate of inflation
increases to 9%. Arlene’s real interest rate on the loan is only 1%. Arlene (the lender) has
suffered because of the unexpected increase in inflation. Professor’s real interest rate paid is also
1%, rather than the 7% real rate Professor expected to pay. Professor (the borrower) has
benefited because of the unexpected increase in inflation.
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Money, Money Creation, and Inflation 10 - 8