Thursday, April 23, 2009

expected inflation rate

Uncertainty about the rate of inflation can introduce the most serious costs of inflation. In a market economy, households and businesses look to prices of goods and assets as signals for resource allocation. For example, an increase in the price of beef relative to chicken encourages farmers to produce more beef and individuals to consume more chicken. An increase in stock market prices relative to the general level of prices is a signal that businesses, prospects are good and that there are opportunities for profitable investment. Relative prices, not individual prices,provide these signals.When inflation fluctuates significantly,relative prices may change in response to general price-level changes, distorting the valuable signals provided by markets. Variations of relative prices because of uncertain inflation cause households and businesses to waste resources investigating price differences.
An extreme case of uncertain inflation occurs in a "hyperinflation,in which the rate of inflation is hundreds or thousands or more percentage points per year for a significant period of time. The costs of hyperinflation are extremely high. Households and businesses must minimize currency holdings,and firms must pay employees frequently. Employees must spend money quickly or convert it to more stable foreign currencies before prices increase further.
A classic example of hyperinflation occurred in Germany after World War I. A burst of money creation by the government ignited inflation,increasing the price level by a factor of more than 10 billion between August 1922 and November 1923. For example, if a candy bar cost the equivalent of 5 cents in August 1922,this increase in the price level would have raised its cost to more than $500,000,000 by November 1923. Our analysis of money balances should plummet. In Germany that proved to be the case; By October 1923,real money balances had shrunk to only about 3% of their August 1922 value. The German hyperinflation ended suddenly in late 1923,with a strong government commitment to stop the printing presses. With a significant decline in growth of the money supply, hyperinflation ended.
Confusing signals from prices are particularly problematic during hyperinflation. With overall prices riding very rapidly,merchants change prices as often as possible. Prices therefore quickly fail to indicate value or direct resource allocation. The government,s tax-collecting ability diminishes significantly during hyperinflation. Because tax bills typically are fixed in nominal terms, households and businesses have a major incentive to delay payment of taxes in order to reduce their real tax burdens.

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