Thursday, April 23, 2009

Unexpected inflation

Many contracts in labor,goods and financial markets are written in nominal terms, cover a substantial period of time, and take expected inflation into account. However, unexpected inflation, or the difference between actual and expected inflation, redistributes wealth. for example, Suppose that a borrower and lender expect no inflation and agree to a one-year,$1000 loan at 4% interest. Regardless of the inflation rate for the year, the lender receives ($1000)(1.04)=$1040 from the borrower at the end of the year. If the actual rate of inflation is 7%, the lender is real return (the return in terms of purchasing power) is- 3%.Conversely, the borrower is real interest rate is -3%. the unexpected inflation of 7% (7%-0%)effectively transferred $70 of real purchasing power from the lender to the borrower. Another example of this redistribution occurs when unexpected inflation reduces real wages for employees with nominal wage contracts.
the implications of unexpected inflation are more difficult to gauge than those of expected inflation for the macro economy. Losses to some parties are matched by gains to others. Nonetheless, for individuals that are risk-averse, the possibility of redistribution can distort behavior.For example, amounts that businesses or households spend on forecasting inflation in order to protect themselves against unfavorable redistributions represent a cost of unexpected inflation.

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