The Costs of Inflation Why is inflation bad? 1 Obviously, because money buys less

THREE MISTAKES Cost of Inflation 2

3 Wages and prices rise and fall together. Inflation does not decrease real wages. 1. People believe inflation decrease real wages If salaries the inflation rate, real wages do not change Prices Wages

The “Robbery Coefficient” Increase in wages = Increase in productivity + increase in prices (inflation) Increase in productivity = 3% Inflation = 2% Increase in wages = 3+2 = 5% 4 2. Workers believe they “earned” 5% and inflation “robbed” them of 2%” Compensate you for rising prices Compensate you for your stellar performance

1 bag of apples = 1 gallon of gas 3 bags of apples =1 gallon of gas No Inflation Change in Relative Prices 3. Inflation is blamed for changes in relative prices.

The True Costs of Inflation Why is inflation bad? 6

1938 Nominal Min Wage $0.25 CPI = 14.1 Real Min Wage = $ Nominal Min Wage $7.25 CPI = 238 Real Min Wage = $3 A $1.20 increase in 75 years! Nominal Min Wage Real Min Wage

1. Inflation Costs: Arbitrary Redistribution of Income Individuals whose incomes are fixed (pensions) or grow slower than inflation (minimum wage) lose purchasing power. Employers who enjoyed sale prices rising faster than wages win… 8 Inflation Arbitrary redistribution of income from minimum wage workers to employers Arbitrary redistribution of income from retirees to government, businesses

5% Inflation = CPI increase by 5% Today Future $100 CPI = 100 CPI = *0.05 =105 (105)/(100) =1.05 (105)/(100) =1.05 Multiply by 1.05 ? Full Basket $100(1.05) = $105 5% Inflation = Nominal value must increase by 5%

Today: you lend $100 I return $100 CPI = 100 CPI =105 You need $105 to buy a full basket Full Basket95% Basket Must protect yourself for Inflation!

To protect from inflation, charge interest If you lend $100 today at 10% interest You get $ (0.1) = = $ $10 is your reward for postponing consumption.

Interest Rate The cost paid by those who want/need to spend today money they will make in the future. 12 The reward for those who give up spending today in order to spend tomorrow

Today: you lend $100 Borrower returns $110 CPI = 100 CPI =105 Charge 10% interest Full BasketFull Basket $105 + $5 your reward for postponing consumption.

CPI =105 Today: you lend $100 Borrower returns $110 CPI = 100 CPI =110 Full BasketFull Basket $110 + $0 Charge 10% interest The borrower is happy. He used your money for free!

Today: you lend $100 Borrower returns $110 CPI = 100 Full Basket90% of Basket $120 Charge 10% interest Gift - The borrower is very happy. He returned “less” than he borrowed! CPI =105 CPI =120

The interest rate written in a contract between lender and borrower The Real Interest Rate Real Interest Rate = Nominal Interest Rate – Inflation Rate % 0% 10% 0% 20% -10% All I need to do is charge the correct Nominal rate! All I need is to be able to see the future inflation rate…

YearInflation What is your guess for inflation in 2014? Average=2.32 ?3

Guess Inflation = 3% Charge 7% nominal interest If you guess right, and inflation is 3%, you will make a 4% real return. Nominal (7%) – Inflation (3%) = Real (4%) If you guess wrong and inflation is 5%, you will make a 2% real return Nominal (7%) – Inflation (5%) = Real (2%) 18

Guess Inflation = 3% Charge 7% nominal interest If you are very wrong and inflation is 26%, you will make a negative return (you are giving money away!) Nominal (7%) – Inflation (26%) = Real (-19%) 19

Guessing Inflation is not easy When past inflation is high and volatile: Argentina, Colombia, Uruguay and Venezuela 20

Guessing Inflation is easier When past inflation numbers are low and stable : U.S. 21

Un-anticipated inflation hurts savers Savings Savers Borrowers Inflation higher than nominal interest Nominal Interest Real interest rate is negative

2. Costs of Inflation: Redistribution of Income Lenders and savers lose Borrowers win 23 Inflation Arbitrary redistribution of income from lenders and savers to borrowers High inflation is volatile and difficult to guess

Capital Gains The difference between the selling price and the purchase price of an asset resulting in a financial profit for an investor. – You purchased Google stock at $300/share in 2012 and sold it for $600 in Capital Gain = 600 – 300 = $300 – You paid $800K for a house in 2011 and sold it for 1M in Capital Gain = 1M – 800K = $200K 24

Interest Income Interest received from an interest bearing asset: – You made a $1,000 loan at 10% interest – You saved $1,000 in an account that pays 10% interest – You bought a government bond that pays 10% interest – You bought a corporate bond that pays 10% interest Interest Income = 1,000 * 0.1= $100 25

Today: you lend $100 Borrower returns $110 CPI = 100 CPI =105 Charge 10% interest Full Basket Full Basket $105 + $5 Interest Tax (35%) = 0.35 *$10 = $3,50 Interest Income = $10 Real Interest = $5 Real Tax = $3,50/5 =0.7 a 70% tax! Borrower returns $110 Inflation increases taxes! CPI =110 Real Interest = $0 Real Tax = $3,50 out of zero + $0 Full Basket $110

Today: you Buy $100 stock Sell for$110 CPI = 100 CPI =105 Full Basket Full Basket $105 + $5 Capital Gains Tax (20%) = 0.2*$10 = $2 Capital Gain = $10 Real Capital Gain= $5 Real Tax = $2/5 =0.4 a 40% tax! Sell for $110 Inflation increases taxes! CPI =110 Real Capital Gain = $0 Real Tax = $2 out of zero + $0 Full Basket $110

Inflation: The most unfair tax… Due to Inflation, Capital gains and interest income are unfairly over-taxed Costs of Inflation

29 higher > 15% Reduced to 0% Before May 03 20% Before May 03 20% 15% 20% same Tax same as ordinary Income < year

30 If you earn $400,000 working you pay 39.6% in taxes If you earn $400,000 selling stock you pay 20% in taxes

The struggle with the administration over increasing taxes on capital gains. 31 “ It’s a war, It’s like when Hitler invaded Poland in 1939.” Stephen Schwartzman, chairman and cofounder of the Blackstone Group, one of the world’s largest private-equity firms.

Who suffers from inflation? People on fixed incomes & Min wage workers (wages/pensions are not fully adjusted by inflation) The poor (government transfers to the poor are not adjusted by inflation). Lenders who guess inflation wrong. Individuals whose incomes come mainly from capital gains and interest income.

Inflation does no special harm to the poor During inflationary periods the prices paid by the poor rise neither faster nor slower than the prices paid by the rest of us. – Inflation does not raise the incomes of the rich relative to those of the poor. The opposite is true: Real incomes at the bottom rise relative to those at the top – Making income distribution slightly more equal. 33

5/25/ Worst2015 Overall105.5 Teens2717 Black or African American Hispanic Men Women White94.7 “When the economy catches a cold minorities and young people get pneumonia” Alan Blinder “When the economy catches a cold minorities and young people get pneumonia” Alan Blinder

1% Unemployment = 2.5% of GDP 35 GDP*0.025 = Goods and Services lost for each 1% extra unemployment 14,000B *0.025 = 350B lost for each 1% extra unemployment

Okun’s Law: an example 2007 Ur = 5% GDP= 12T 2008 Ur = 9% Extra Unemployment = 9– 5= 4% For each 1% extra unemployment we lose 2.5% of GDP: % Lost GDP = 4(2.5) = 10% Lost GDP = 12T (0.10)= 1.2T Production lost that can not be recovered.

5/25/2015 (c) 2002 Claudia Garcia-Szekely 37 Majority of those who are unemployed find jobs in less than 5 weeks

5/25/2015 (c) 2002 Claudia Garcia-Szekely 38 Majority of those who are unemployed find jobs in less than 5 weeks Majority of those who are unemployed are unemployed for more than 6 months

VIDEO 5/25/2015 (c) 2002 Claudia Garcia-Szekely 39

The Phillips Curve If we plot past data on Inflation and unemployment we observe: There is a temporary trade off between inflation and unemployment 40 Inflation Unemployment Years of High Inflation Years of Low Inflation Years of Low Unemployment High Unemployment

The trade off between unemployment and inflation To reduce inflation by 1%, we must increase unemployment above the natural rate by 2% 41

Unemployment Inflation 10%

The trade off between unemployment and inflation A reduction in inflation from 10% to 4% (6%) costs (6x2) 12% in terms of extra unemployment… 43 Paul Volcker: Chairman of the Federal Reserve under Jimmy Carter and Ronald Reagan (from August 1979 to August 1987)

Unemployment above the NRU (5.8%) : 1.3 points 1981: 1.8 points 1982: 3.9 points 1983: 3.8 points 1984: 1.7 points Total: 12.5 points Between 1980 and 1985 a 6% reduction in inflation cost unemployment to be 12.5% points above the natural rate.

5/25/2015 (c) 2002 Claudia Garcia-Szekely 45 High inflation call the Fed! Fed works it’s magic through unemployment

Unemployment Inflation Bush Clinton Bush Oba ma 09-

5/25/2015 (c) 2002 Claudia Garcia-Szekely 47 Less than HS HS graduates Some College Bachelor Degree and higher 11.2% 7.9% 6.7% 3.8%

STAY IN SCHOOL How do you protect yourself from unemployment? 5/25/2015(c) 2002 Claudia Garcia-Szekely48

5/25/2015 (c) 2002 Claudia Garcia-Szekely 49 Deflation The Great Recession