Inflation Types: Perfectly and Imperfectly Anticipated Inflation

There is no direct loss of output from inflation as compared to unemployment.

There are two types of inflation:

I. Perfectly anticipated inflation.

II. Imperfectly anticipated inflation/Unanticipated inflation.

I. Perfectly Anticipated Inflation:

When the inflation can be predicted, it is called perfectly anticipated inflation.

If an economy has been experiencing a given rate of inflation-say 6% for the last four years, then people will anticipate that the rate of inflation will continue to be 6%. All contracts would be made on the basis of expected 6% inflation rate.

During inflation, debtors will gain and creditors will lose. To avoid this, the nominal interest rates are raised by 6% by the lender. Long-term labour contracts would increase wages by 6%, tax brackets would be increased by 6% per year.

Thus, there will be no real cost of inflation except for two costs:

(i) Shoe leather cost:

When the inflation rate increases, the nominal interest rate rises, interest lost by holding currency rises because demand for real balances is inversely related to the nominal interest rate.

Result:

The demand for currency falls. People will prefer to invest money in interest yielding bank deposits rather than holding cash in hand. In such a situation, Individuals will have to do with less currency and make more trips to banks to cash smaller cheques than they did before. This causes inconvenience to the people. By diverting this time and energy from production and investment, inflation makes the economy run less efficiently.

The inconvenience caused due to making frequent trips to the banks is described as the ‘Shoe – Leather’ costs of inflation.

(ii) Menu cost:

Hotels, Restaurants etc. use catalogues to inform their customers about the price of goods being served by them. Due to inflation, they will have to incur menu cost because they have to devote more real resources to change their printed prices, rate list, vending machines, cash registers etc.

The cost of perfectly anticipated inflation will depend on the inflation rate. If the inflation rate is moderate, the cost will be low; but under hyper inflation, cost will be very high.

II. Unanticipated Inflation:

Anticipated inflation is very rare. In fact actual inflation is different from the expected one. When the inflation rate is higher or lower than that has been expected it is unanticipated inflation. Most of the time, the rate of inflation is not the one which was anticipated, therefore, it causes problems. Unanticipated inflation introduces an extra element of risk.

Cost of Unanticipated Inflation:

(i) On decision making:

During inflation, contracts are made in nominal terms because if inflation is high, then the borrowers will pay less. Because of fall in the value of Rupee in real terms, lenders will lose. But if inflation is lower than expected, there is a loss to debtor. Thus, someone wins and someone loses. This element of risk is a cost of unanticipated inflation which is difficult to measure.

(ii) Wealth Redistribution:

During inflation, real value of assets fixed in nominal terms falls. The purchasing power of all claims or assets fixed in money terms decreases.

Effect:

(a) Pensioner loses because he gets a fixed pension. During inflation with a fixed Rupee pension, the pensioner finds that his income can buy only a small fraction of what it did at retirement. This is because pension is like a loan for creditors to the debtors (firm), Government gains and pensioner loses. However, gains would depend on whether unexpected inflation is higher or lower than the expected one.

(b) If inflation is more than expected, the debtors (borrowers) gain and creditors (holders of bond, lenders) lose because the debtors have to pay loans with less valuable Rupee.

The household sectors are the creditor in nominal terms. Due to inflation of the real value of households the nominal creditor position is eroded. Wealth is, therefore, transferred from creditors to debtors and from pensioners to firms.

For example:

A land has been mortgaged for 30 years at the rate of interest of 6% per year based on low expected inflation rate of 4%.

Expected Real Return → 2% (6 – 4%)

But over 30 years inflation rate averaged 5%.

Real Return will be only 1% (6 – 5%).

The debtor benefited and the creditor lost.

(c) Income received:

Since wages are fixed in nominal terms. The employee loses and employer benefits if the inflation is more than expected.

P > P* → Employee loses P* → Price based on expected inflation

P < P* → Employee benefits.

(d) Tax liabilities:

Due to inflation people move into higher tax brackets which decreases their real disposable income. This is because when inflation is more than expected, it causes price to rise.

(e) Old people are more vulnerable to inflation than the young one because old people own more nominal assets.

(f) According to Mankiw:

When the Government gains from inflation, private sector pays less taxes but corporate sector gains from inflation, they benefit at the expense of others. As a result, cost of unanticipated inflation will be negligible if we do not take into account redistributing wealth among individuals.

Mr. X takes a loan worth Rs. 100 from Mr. Y @ 10% interest rate in 1980 when rate of inflation was 2%. The loan is to be repaid in 1985. In 1985 inflation rate was 5%. Mr. X will pay only Rs. 110 but due to inflation the value of money has fallen and therefore Mr. X pays less in real terms and Mr. Y receives less. Thus, the debtor gains and the creditor loses.

(g) Unanticipated inflation means that prices rise faster than wages which leads to an increase in profits. But US evidence reveals that the real value of dividends decreases and equity holders are hurt by unanticipated inflation.

(h) When people are uncertain about current and future price level, they find it difficult how to respond to the changes in price. It means inflation decreases the efficiency of price system. This decreases the efficiency with which the economy allocates the goods and factor and affect the output level. Therefore, high inflation is bad for the economy.