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# 10

INFLATION

Prepared by:
MARIA FRANCESCA TOMALIWAN
De La Salle University

OVERVIEW
Classical Dichotomy
Money Neutrality
Fisher Effect
Inflation-induced tax distortion
Arbitrary redistributions of wealth

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THE CLASSICAL DICHOTOMY

David Hume and his contemporaries (18th century)
wrote that economic variables should be divided
into two groups

Nominal variables: variables measured in monetary
units
Real variables: variables measured in constant units

Relative prices are real variables
For example, real wage (adjusted for inflation) is a real
variable

The division of variables into these two groups is called
the classical dichotomy.
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MONEY NEUTRALITY

David Hume and others suggested that the
classical dichotomy is useful because different
forces influence real and nominal variables
Real variables do not change with changes in the
money supply.
Changes in the money supply affect nominal
variables but not real variables.
The irrelevance of monetary changes for real
variables is called monetary neutrality.

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MONEY AND PRICES DURING FOUR
HYPERINFLATIONS

(a) Austria

(b) Hungary

Index
(Jan. 1921 = 100)

Index
(July 1921 = 100)

100,000

100,000
Price level

Price level

10,000

10,000

Money supply

1,000
100

Money supply

1,000

1921

1922

1923

1924

1925

100

1921

1922

1923

1924

1925

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THE FISHER EFFECT

According to money neutrality theory, real interest rate
is not influenced by monetary changes
Recall:

Re-arranging, we have
Nominal interest rate=real interest rate + inflation rate

Real interest rate=nominal interest rate-inflation rate

Change in the inflation rate

change in nominal interest rate

The Fisher effect refers to a one-to-one adjustment of the
nominal interest rate to the expected inflation rate.

when the rate of inflation rises, the nominal interest rate
rises by the same amount.
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THE COSTS OF INFLATION

Shoe-leather costs: the costs of reducing money
holdings
Menu costs: the costs of updating prices
Relative-price variability: the costs associated with
relative price distortion:
Confusion & inconvenience: with rising prices, it is
harder to compare real revenue prices, costs and
profits over time.
Tax distortions
Arbitrary redistributions of wealth
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INFLATION-INDUCED TAX DISTORTION
Inflation exaggerates the size of capital gains and
increases the tax burden on this type of income.
With progressive taxation, capital gains are taxed
more heavily.

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INFLATION-INDUCED TAX DISTORTION
The income tax system treats the nominal
interest earned on savings as income, even
though part of the nominal interest rate merely
compensates for inflation.
The after-tax real interest rate falls, making
saving less attractive.

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HOW INFLATION RAISES THE TAX BURDEN
ON SAVING
Economy 1
(price
Economy 2
stability) (inflation)
Real interest rate (r)

4%

4%

Inflation rate

0%

8%

Nominal interest rate (i)

4%

12%

Reduced interest due to 25% tax
=(0.25*i)

1%

3%

After-tax nominal interest rate
After tax i=(0.75*i)

3%

9%

After-tax real interest rate
(after-tax i– inflation rate)

3%

1%

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ARBITRARY REDISTRIBUTIONS
OF WEALTH
Unexpected inflation redistributes wealth among
the population in a way that has nothing to do
with either merit or need.
These redistributions occur because many loans
in the economy are specified in terms of the unit
of account — money.

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