The costs of inflation, deflation and disinflation

A nominal interest rate is measured in rupees; a real rate is measured in what the rupees will buy. Lend Rs 100 at 30% and you get back Rs 130. If prices rose 20% meanwhile, those Rs 130 buy what Rs 108.33 bought at the start, so your real return is 8.33%. That is the exact relation:

Papers use both. “The real rate of interest is normally calculated by subtracting the rate of inflation from the nominal rate” is the keyed answer in JNU 2013, and a 6% rate with 5% expected inflation gives 1% in Hyderabad 2016. But when the rates are large and the question says “approximately”, as in Hyderabad 2014, the keyed answer is the exact one: 1.30 ÷ 1.20 − 1 = 8.3%, while subtracting gives 10%.

If lenders expect inflation, they ask for a higher nominal rate to protect the real return. So nominal rates tend to be high when inflation is high and low when it is low: this is the Fisher effect (UGC NET 2024), and the nominal rate is the real rate plus expected inflation. The difference between the nominal and the real rate is inflation (Hyderabad 2014). The next chapter shows what the “expected” is doing there.

On the first tab a loan is priced to expected inflation and repaid after actual inflation. Press “Inflation above what was expected” and then “Prices fall”, and watch who gains. The second tab is JNU 2011’s tax question.

Inflation confers no benefit on society but imposes several real costs. The papers list five, and a question that asks which are costs has all five as its keyed answer (UGC NET 2024):

• Shoe-leather costs. Money loses value in your pocket, so you hold less of it and make more trips to the bank. The effort is a real cost.
• Menu costs. Prices have to be changed more often: printing new menus, catalogues and price tags, and the time spent deciding.
• Variability of relative prices. Firms change prices at different times, so relative prices wobble for no economic reason, and people make worse decisions.
• Tax distortions. Tax codes that are not indexed tax nominal gains: the second tab above shows a 30% tax on a 20% nominal profit with 5% inflation taking 40% of the real profit.
• Arbitrary redistribution of wealth. Debts fixed in rupees change in real value, so unexpected inflation moves wealth from lenders to borrowers, and deflation does the reverse (Hyderabad 2015). Inflation is therefore bad for those who lend and hold claims fixed in money (Hyderabad 2010), and the statement that inflation lowers the nominal value of wages while raising their real value is false (Hyderabad 2020).

Anticipated against unanticipated. If inflation is expected, contracts adjust: nominal rates and wages are set to allow for it, and the redistribution largely disappears, though the first four costs remain. It is the surprise that moves wealth.

A government can pay for spending by creating money. The real revenue it raises that way is seigniorage (DSE 2013): the real value of the new money it creates. Its cost falls on those who hold money, whose balances lose value as prices rise, which is why economists call it an inflation tax. The tax rate is the inflation rate and the tax base is the real money people hold.

Here is the catch. As inflation rises, people hold less money, so the base shrinks. Revenue is inflation times real balances: it rises with inflation at first, reaches a peak, and then falls. A government that prints ever faster in a hyperinflation collects less each year.

Deflation is feared even though cheaper goods sound welcome, because debts fixed in rupees become heavier: borrowers lose and lenders gain (Hyderabad 2015), borrowers cut spending, and demand weakens further. Disinflation is often the aim of policy, and Lesson 10 asks what it costs.