Describe the three major costs of unanticipated inflation and give an example of each.

Question

What will be an ideal response?

Answer 1

First, prices are set wrong because some prices and wages must be set in advance before the inflation rate is known. Thus prices and wages may be at incorrect levels, causing some workers and businesses to lose because of incorrect relative prices. For example, a labor union might agree to a 4 percent cost-of-living adjustment when inflation turns out to be only 2 percent, causing real wages to be too high and possibly leading the firm to lay off workers. Second, wealth is redistributed between borrowers and lenders who have agreed to a fixed nominal interest rate. For example, if the expected real interest rate is 2 percent, and expected inflation is 3 percent, the nominal interest rate will be 5 percent. If inflation turns out to be 5 percent, then the realizing real interest rate is 0 percent, so borrowers gain and lenders lose. Third, higher inflation leads to greater uncertainty about the future inflation rate, which may change economic decisions. For example, when the inflation rate is 10 percent, a business firm considering investing in physical capital faces great uncertainty about its real return, so it may choose not to invest.