Question

1. An American politician recently said "If inflation is fully anticipated by all parties, the redistributional effects would be almost nothing. It's the fact that some inflation is a surprise that causes there to be winners and losers during an inflationary period." Do you agree with this statement? Is it true that there are no costs of anticipated inflation? Explain the costs associated with expected inflation and the costs associated with unexpected inflation.

2. In 2002, the U.S. CPI was 100. In 2003, the U.S. CPI was 107. If you had $20,000 in your bank account at the beginning of 2002, would you have been better off if you had kept the $20,000 in cash (money), used $20,000 to buy an interest-bearing financial asset paying a nominal interest rate of 6%, or using the $20,000 to buy a real asset (like art or gold)? Explain your answer. (What is the real return on each asset?)

Answer 1

1. Even if inflation is fully anticipated, not all firms would be willing to raise wages immediately, they would first seek more profits and then justify the increase in wages. Thus even if inflation is fully anticipated, the redistributional effects are not immediate which reduces consumption in the economy as the purchasing power of the currency reduces. Thus I don't agree with this statement, cause even if inflation is anticipated there are still losers such as fixed deposit earners and old people who have their savings invested in fixed income.

Thus there are costs of anticipated inflation wherein the currency is devalued and people reduce their consumption as the prices increase, which reduces the demand.

Costs associated with expected inflation are that people will hold less cash in hand and will rely on internet transactions as the value of the currency has decreased, thus they would prefer to keep money in the bank accounts. Firms would have to keep updating the price in advance.

Costs associated with unexpected inflation are that it leads to inequal distribution of wealth in the economy. It increases the level of unemployment, reduces the level of investments and profits as input costs for firms increase.

2. 2002: CPI was 100. In 2003: it was 107. Thus the inflation increased by {(107/100)-1} *100 = 7%

Keeping money in cash wouldn't make the person better off as the $20,000 is able to buy less goods in 2003 because of 7% inflation.

$20,000 to buy an interest bearing financial asset paying a nominal interest rate of 6% which is lower than the inflation rate. If the real interest rate excluding inflation was higher than it would have been a great investment. But the nominal interest rate which includes inflation is itself 6%, which means the real interest rate is -1% (6% - 7% inflation level)

Thus the person would be better off buying a real asset like art or gold, as its value appreciates over time. Plus in times of recession gold prices increase drastically as it is considered a safe haven asset.