Since it is impossible to gauge with any accuracy the future
rate of inflation in countries that have any variability in their
inflation rates, wealth effects of deviations of the actual from
the expected inflation rates in these countries are inevitable.
An excess of the actual over the expected inflation rate results
in a redistribution of wealth from creditors to debtors while an
excess of expected over actual inflation redistributes it in the
opposite direction.
It is natural that people will attempt to find ways to avoid
the wealth effects of unanticipated inflation. One way is to
hold one's wealth in real capital goods such as real estate,
automobiles, etc., or in shares in firms that hold real capital.
Since the future earnings of these assets tend to rise and fall
proportionally with the general level of prices, their present
values, and market prices, are insulated in large part from the
effects of unanticipated inflation (and anticipated inflation as
well).
Avoiding nominally fixed assets, however, has the side
effect that the benefits from borrowing and lending through this
type of financial instrument are also lost. Bonds, mortgages,
personal loans, and other nominally fixed assets exist because
people want to hold their wealth in this form. They want this
partly to avoid the risks of fluctuation in market value associated
with changes in common stock prices and real estate values
and partly because they want liquidity---to able to convert their
assets into a predetermined amount of cash at any time. Also,
these types of debt instruments represent the cheapest and often
the only method through which individuals and firms can borrow
in certain situations---home mortgages are an example.
As unanticipated price level changes become larger and
more frequent, the risks from holding nominally fixed obligations
become greater and wealth holders seek ways of reducing them.
One way is through the indexing of contracts.
Suppose that you are aware of the possibility of major
changes in the price level but you can't predict the timing,
magnitude or direction of these price level changes. You might
nevertheless be willing to make a loan to someone if provisions
can be incorporated into the contract to protect you against
unforseen inflation. One way of doing this is to denominate the
loan in real today's dollars rather than nominal dollars.
Suppose you loan out $1000 for one year at 5 percent under
an agreement that the amount to be paid back will equal $1000
plus $50 interest, with both principal repaid and interest
multiplied by the percentage change in the consumer price index
between this year and next. If the inflation rate turns out to
be 40 percent, you will receive $1470; if it turns out to be 5
percent, you will receive $1102.50; and if the price level falls
by 10 percent, you will only receive $945. In each case, the
amount you receive will enable you to purchase $1050 worth of
the bundle of today's goods that is used in constructing the
consumer price index. You are guaranteed to receive 5 percent
real interest, where "real" means measured in units of
today's CPI bundle.
In the case above where the loan is indexed, the person
borrowing the funds would also be protected because he/she only
has to pay back the real value of what is borrowed at a reasonable
realized real interest rate. Potential gains from
unanticipated inflation are offset by protection from the loss
that would occur if inflation is less than anticipated.
This principle of indexing can be (and is) applied in
a wide variety of areas---income tax rates and old age security
payments are indexed in the United States, for example, and civil
servants' pensions are indexed in Canada.
Markets for indexed bonds, mortgages and other securities
are frequently found in countries experiencing very substantial
price level variability---where inflation rates may vary, for
example, between 50 and 100 percent per year. We do not observe
them in countries like the United States and Canada, however,
where the maximum inflation rates experienced in the Post-War
period have been less than 15 percent and the average inflation
rate has probably been under 5 percent. Why is this?
One reason is that there are many different possible measures
of the price level, depending on the bundle of goods used
in calculating the price index. A suitable measure for one
person might not be suitable for another. Unanticipated changes
in relative prices through time will favor some individuals at
the expense of others, depending on the bundle of goods they
consume. Indexing using the CPI for example may hurt a particular
borrower if the CPI falls but the bundle of items that
person consumes nevertheless rises in price. Lenders, of
course, can lose in a similar way.
Indexing thus carries its own risk to both lenders and
borrowers. Both parties must expect that their risk of loss will
be reduced, on average, if indexed contracts are to be widely
entered into.
If, based on past experience, the unanticipated movements
in the price level are likely to be small, the risks from indexing
itself may be greater than the risks from unanticipated
inflation. If unanticipated price level movements are large and
frequent, however, the risks of unanticipated inflation or
deflation will exceed the risks associated with adopting a
particular index bundle and indexing will be worthwhile.
Indexing is therefore more likely to be observed in countries which
tend to experience a lot of price level variability
and less likely in countries whose inflation rates have tended
historically to be quite stable.
Now comes a test. Before looking at the answers provided, be sure
and think up ones of your own.
You have learned how unanticipated inflation redistributes
wealth from asset holders who own the right to receive fixed
nominal amounts in the future to debtors who have the obligation
to pay those fixed amounts. Where the inflation is anticipated,
these borrowers and lenders will get around this problem by
incorporating in the interest rate a premium equal to the expected
future rate of inflation. This will compensate for the expected
effect of inflation on the real value of the principal and
interest over the term of the loan.