As consumers, we are all aware that items come with a price tag that we must pay in order to obtain them. While we are always on the lookout for a good deal, what if there was none to be had since the general level of goods prices continued to rise? Would you buy the goods nonetheless, or would you postpone your purchase? This is the general concept of inflation, and it is known as unanticipated inflation when it occurs suddenly.
So, what exactly is inflation, and does it always happen at the most inconvenient times? To begin with, inflation is a continuous rise in the general price level of things. Second, inflation does not always strike out of nowhere. In truth, inflation can be unexpected as well as predicted. However, we must distinguish unplanned inflation from anticipated inflation in order to completely comprehend it.
Anticipated inflation arises when people anticipate inflation and plan accordingly. Increased interest rates, for example; if inflation is expected, banks can try to protect themselves by raising interest rates. When people are unaware that inflation is coming until after the general price level has risen, this is known as unanticipated inflation. Many people are left defenseless when this happens, such as lenders who are paid back with money that has a lower purchasing power.
What is the difference between inflation that is expected and inflation that is unexpected?
The component of inflation that economic agents expect to occur is known as expected inflation. It’s what they’ve already incorporated into their business decisions. Unexpected inflation is the component of inflation that people haven’t factored into their pricing, costing, and other calculations.
What is the expected inflation rate?
Anticipated inflation is the percentage increase in the level of prices that people in an economy expect over a particular period. Consider a loaf of bread or any form of consumer staple that you buy on a daily basis. It’s safe to assume that the cost of that staple will rise over time. Bread probably didn’t cost the same twenty or thirty years ago as it does now.
In what circumstances does inflation occur, both expected and unexpected? What are the consequences?
Inflation is a measure of the total increase in market prices. Consumers anticipate inflation based on business cycles, but they do not anticipate surprise inflation. Wealth is shifted from lenders to borrowers in the event of unanticipated inflation. Changes in purchasing power and real interest rates cause this arbitrary redistribution. Unexpected inflation has the advantage of increasing borrowers’ savings since they repay their debts with money that has lost purchasing value, as shown in the example of unexpected inflation. Unexpected inflation has a negative impact on lenders and people on fixed incomes, but it has a beneficial impact on borrowing.
What is the issue with inflation expectations?
We’re now looking at a scenario in which everyone knows what the inflation rate will be between now and next year. Let’s say you’re lending $100 for a year and you predict inflation to be 10% during the next year. To compensate the loss in real value of the principal during the year, you must charge 10% interest-the $100 you would receive on repayment at the end of the year will only buy $90 worth of products. You also want to earn real interest on the loan, say 5%, so you’ll have to charge a 15 percent interest rate5% real interest and 10% to account for inflation.
Because 10 of the 15 percentage points will be offset by the predicted reduction in the amount of actual goods that will have to be paid back to discharge the debt, the individual borrowing $100 from you will be willing to pay interest at 15% each year.
Of course, this requires that the borrower likewise expects inflation to be 10% per year and is willing to borrow from you at a 5% real interest rate per year.
In this situation, the contracted real rate of interest (sometimes referred to as the “ex ante” real rate) is 5% each year.
The realized (or “ex post") real interest rate will be determined by the actual rate of inflation, which will typically differ from the inflation rate you and the borrower are anticipating.
If inflation is higher than projected, the realized real interest rate will be lower than the contracted real interest rate, resulting in a wealth redistribution from you to the borrower.
If inflation is lower than projected, the ex post real interest rate will be higher than the ex ante real interest rate, and you will profit at the expense of the borrower.
There will be no wealth redistribution effect if the actual and predicted inflation rates are the same.
Only the unforeseen fraction of inflation or deflation results in wealth transfers between debtors and creditors; the rest is accounted for in the loan contract’s interest rate.
We can now approximate the link between nominal interest rates and inflation expectations.
The lender will demand, and the borrower will be willing to pay, an interest rate equal to the real rate of interest earned by investing in cars, clothes, houses, and other items, plus (minus) the expected rate of decline (increase) in the real value of the fixed amount that the borrower must repay due to inflation (deflation).
As a result, the nominal interest rate must equal the real rate plus the predicted inflation rate.
where e is the predicted yearly rate of inflation during the loan’s tenure and r is the contracted real interest rate.
The nominal interest rate I is, of course, a contracted rate.
The Fisher Equation is named after the economist Irving Fisher (1867-1947).
The relationship between the nominal interest rate, the realized real interest rate, and the actual rate of inflation that occurs over the life of the loan can be expressed using a similar equation.
2. I = rr + rr + rr + rr + rr + rr
where rr is the realized real interest rate and is the actual rate of inflation that occurs during the loan’s tenure.
2. rr – r = e – rr – rr – rr – rr – rr –
When inflation exceeds expectations, the realized real interest rate falls below the contracted real interest rate.
The lender loses money, while the borrower makes money.
The realized real interest rate rises above the contracted real interest rate when inflation is lower than projected.
The lender wins while the borrower loses.
It’s time to put your skills to the test.
You should first come up with an answer of your own before accessing the offered answer.
Is inflation that is expected or unexpected worse?
When the rate of inflation differs from expectations, the amount of interest repaid or earned differs from what they expected. Unexpected inflation hurts lenders since the money they are paid back has less purchasing power than the money they lent out.
Quizlet: What is the impact of unexpected inflation?
What are the consequences of unexpected inflation? Unprecedented inflation results in arbitrary income redistributions.
Expected Inflation:
Take, for example, the instance of projected inflation. The distortion of the inflation tax on the amount of money people hold is one of the costs of predicted high inflation. A higher inflation rate causes a higher nominal interest rate, which causes real balances to fall. People must make more frequent journeys to the bank to withdraw money if they are to have lower average money balances. The shoe-leather cost of inflation refers to the inconvenience of lowering money holding.
A second cost of inflation emerges as a result of high inflation, which encourages businesses to modify their pricing more frequently. Changing prices can be costly, as it may necessitate the printing and distribution of a new catalogue. Because restaurants must print new menus more frequently as the rate of inflation rises, these expenditures are referred to as menu costs.
What is inflation and what are its numerous types?
- Inflation is defined as the rate at which a currency’s value falls and, as a result, the overall level of prices for goods and services rises.
- Demand-Pull inflation, Cost-Push inflation, and Built-In inflation are three forms of inflation that are occasionally used to classify it.
- The Consumer Price Index (CPI) and the Wholesale Price Index (WPI) are the two most widely used inflation indices (WPI).
- Depending on one’s perspective and rate of change, inflation can be perceived favourably or negatively.
- Those possessing tangible assets, such as real estate or stockpiled goods, may benefit from inflation because it increases the value of their holdings.
Who are the folks who are most affected by unexpected inflation?
Let’s go over everything again. While inflation can cause problems for a variety of people and businesses, the manner in which inflation happens often determines who is most affected and how.
When the general price level changes abruptly, this is known as unanticipated inflation. Those who are retired or on a fixed income, as well as lending institutions, appear to be the hardest afflicted. While banks may be having a difficult time, borrowers might benefit from unanticipated inflation by receiving lower interest rates and paying less on their loans over time. Finally, when something unexpected happens, there is always a positive and negative side to the issue, just as there is with inflation.
Unexpected inflation would assist which of the following groups of people?
Unexpected inflation hurts lenders since the money they are paid back has less purchasing power than the money they lent out. Unexpected inflation benefits borrowers since the money they repay is worth less than the money they borrowed.