AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/2/2-5)
Unit 2 · Topic 2.5
2.5 Costs of Inflation
Inflation that nobody saw coming shifts wealth from some people to others, mainly from lenders to borrowers and away from people whose income is fixed in dollars. Inflation that everyone expects causes much less harm, because people build it into their contracts. Smaller costs, like constantly updating prices, add up too.
Key terms
- unexpected inflation
- redistribution of wealth
- fixed income
- menu costs
- shoe-leather costs
Why unexpected inflation redistributes wealth
Loans and many incomes are written in dollars. When prices rise faster than people expected, each dollar buys less than they planned, so whoever receives a fixed number of dollars loses buying power, and whoever pays a fixed number of dollars gains.
The tool for seeing this is the real interest rate: real interest rate ≈ nominal interest rate − inflation rate. The nominal rate is the rate written on the loan. The real rate is what the lender actually earns in buying power. You'll use this formula again in 4.2.
Winners and losers
Why does "unexpected" matter? If everyone expects 4% inflation, lenders simply charge 4 percentage points more in interest and workers bargain for raises that cover it. Expected inflation is built in, so it doesn't shift wealth the same way. Problems come from surprises.
That's why lenders set the nominal rate to cover both the real return they want and the inflation they expect: nominal rate ≈ real rate + expected inflation. A lender who wants a 3% real return and expects 2% inflation charges about 5%.
Some incomes are protected automatically. Social Security benefits get a yearly cost-of-living adjustment (COLA) tied to a price index, and some union contracts do the same. People with these adjustments are hurt much less by inflation than people whose pay is fixed in dollars.
| Group | Unexpectedly high inflation | Unexpected deflation |
|---|---|---|
| Borrowers with fixed-rate loans | Gain: repay with dollars worth less | Lose: repay with dollars worth more |
| Lenders and savers at fixed rates | Lose | Gain |
| People on fixed incomes (some pensions, fixed rent received) | Lose buying power | Gain buying power |
| Workers with wages fixed by contract | Lose until wages catch up | Gain until wages adjust |
Other costs of inflation
- Menu costs: businesses spend time and money changing prices on menus, websites and price tags.
- Shoe-leather costs: when cash loses value quickly, people spend effort keeping less of it, like making extra trips to the bank. The name comes from wearing out your shoes.
- Uncertainty: when inflation is high and unpredictable, it's harder for households and businesses to plan, sign long contracts or save.
- Unit-of-account problems: rising prices make it harder to compare values over time, and some taxes aren't fully adjusted for inflation.
Worked examples
Try each one yourself first, then open the solution.
- Example 1
Who wins on a loan?
Maya lends Sam $1,000 for one year at a 5% nominal interest rate. Both expect 2% inflation. Inflation actually turns out to be 7%. (a) What real interest rate did Maya expect to earn? (b) What real rate did she actually earn? (c) Who gained and who lost?
Show the solutionHide the solution
- Step 1: (a) Expected real rate ≈ nominal − expected inflation = 5% − 2% = 3%.
- Step 2: (b) Actual real rate ≈ nominal − actual inflation = 5% − 7% = −2%. The $1,050 Sam repays buys less than the $1,000 Maya lent.
- Step 3: (c) Inflation was higher than expected, so the borrower (Sam) gained and the lender (Maya) lost.
Answer: (a) About 3%. (b) About −2%. (c) Sam, the borrower, gained; Maya, the lender, lost.
- Example 2Calculator allowed
Fixed income (classic trap)
Rosa receives a pension of exactly $2,000 a month that never changes. Over the next year, the price level rises 10%. A classmate says her buying power fell by exactly 10%. Is that right?
Show the solutionHide the solution
- Step 1: Her real income in today's dollars is $2,000 ÷ 1.10 ≈ $1,818.
- Step 2: That's a drop of about $182, or 1 − 1 ÷ 1.10 ≈ 9.1% of her buying power.
- Step 3: So the classmate has the direction right but the number a little off. For small inflation rates, "about the same as the inflation rate" is a fine estimate, and AP questions usually ask only whether a group gains or loses.
Answer: She loses buying power, about 9.1% (her $2,000 now buys what about $1,818 bought before). The key point: people on fixed incomes lose from unexpected inflation.
Common mistakes
- Saying borrowers lose from inflation. With fixed-rate loans, unexpected inflation helps borrowers and hurts lenders.
- Ignoring the word "unexpected." Inflation that was correctly expected is already built into interest rates and wages.
- Forgetting that deflation reverses the winners: unexpected deflation hurts borrowers and helps lenders.
- Subtracting in the wrong order. Real rate = nominal rate − inflation, not inflation − nominal.
On the exam
- Questions typically describe a group (savers, borrowers, retirees on fixed pensions, workers with contracts) and ask whether unexpected inflation or deflation helps or hurts them. Say why in terms of the value of the dollars they pay or receive.
- You may need to compute a real interest rate from a nominal rate and an inflation rate, which is a quick subtraction.
Connected topics
Videos
Check yourself
4 questions on 2.5 Costs of Inflation. Pick an answer to see if you got it, and why.
Inflation turns out to be much higher than everyone expected. Which of the following people is most likely to benefit?
A retired teacher receives a pension of $3,000 a month that will not be adjusted for inflation. If the price level rises 10 percent more than expected, the teacher's
A college student takes out a fixed-rate loan. Over the life of the loan, the price level unexpectedly falls. Who is most likely to gain from this deflation?
Borrowers and lenders both correctly expect 4 percent inflation next year and write their loan contracts with that in mind. If inflation turns out to be exactly 4 percent, then
0 of 4 answered