We all hear talking about inflation, but how does it really work?

It is define as the rate of change of prices, and the change can be more or less fast (if it is really high we are talking about hyperinflation); positive or negative (deflation). If we have a little amount of inflation it doesn’t mean that prices aren’t growing: it just means that they are growing slowly.

Suppose that an economy has been experiencing a given rate of inflation, say, 4 percent for a long time. Wouldn’t you expected the same rate of inflation for the following year? This is the concept of rational expectations, developed by the Chicago School of Economics, that postulated that: rational agents (as we all are, following the assumptions of economic theory) have rational expectations. This means that everyone in that economy expect the inflation rate to continue its path. The consequences, the costs, of this inflation are very little: it is called anticipated inflation. We have two types of costs:

  • Cost of holding currencies, because money not deposited in banks loose more and more value;
  • What is called menu cost, which are the real resources that people have to gave up in order to marking up prices, changing pay telephones, cash registers…
    But at such low to moderate inflation rates, the cost of fully anticipated inflation are small.Inflation up by 4.8% in May

What happens if everybody is wrong? In this scenario we talk about imperfectly anticipated inflation:

  • Most contracts are written in nominal terms (which is to say the numbers written on the paper) so the real value of those amounts changes;
  • We have an effect of wealth distribution: “inflations redistributes wealth between debtors and creditors […] It benefits capitalists or recipient of profit income at the expense of wage earners. Unanticipated inflation means that prices rise faster than wages and therefore allow profits to expand.”

Is a little inflation good for the economy?

James Tobin argued that a small amount of inflation is good for the economy – and reduces the natural rate of unemployment – because it provides a necessary mechanism for lowering real wages without cutting nominal wages. The argument is: in a changing world, some real wages need to go up and some need to go down in order to achieve economic efficient and low unemployment. It is easy to raise real wages simply by raising nominal wages quicker than inflation, but to cut real wages firms must hold nominal wage increases below the rate of inflation. At a zero inflation, firms would have to cut paychecks by the amount of inflation, but this is really complicate and cause discontent between workers.”

- Macroeconomics; Dornbusch, Fischer, Startz; Mc Graw Hill international edition, 12th edition



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