Understanding Expected and Unexpected Inflation | CFA Level I Economics

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

Welcome back as we dive into inflation from the central bank’s perspective. We’ll explore the Fisher effect, the costs of expected and unexpected inflation, and their implications on the economy.

The Fisher Effect and Money Neutrality

The Fisher effect states that the real rate of interest in an economy is stable over time, and changes in nominal interest rates are due to changes in expected inflation. Therefore, the nominal interest rate is the sum of the required real rate of interest and the expected rate of inflation.

This is consistent with money neutrality, which we learned in the previous lesson: an increase in the money supply will result in an increase in price levels when all else remains equal. Over the long term, the growth in money supply should not affect the real interest rate but will influence inflation and inflation expectations.

Nominal Interest Rates: Three Components

Investors can never be sure about future inflation and real growth. To compensate for this uncertainty, they require a risk premium. Nominal interest rates consist of three components:

• A required real return
• A component compensating investors for expected inflation
• A risk premium to compensate investors for uncertainty

Expected and Unexpected Inflation

Expected inflation is the level of inflation that the government, households, and businesses anticipate in the future. Unexpected inflation is the level of inflation experienced that is above or below the expected inflation.

We differentiate between the two because unexpected inflation is much more costly to the economy than expected inflation. Let’s examine the costs of inflation in more detail.

Costs of Expected Inflation

Regardless of whether it is expected or not, high inflation always means that businesses constantly have to change the advertised prices of their goods and services, known as menu costs. Another cost is the shoe leather costs, which are costs to individuals of making frequent trips to the bank to minimize their holdings of cash, which are depreciating in value due to inflation. While technology has reduced these costs, high inflation increases the implicit cost of holding money rather than interest-bearing securities, as the purchasing power decreases at a faster rate. People tend to shift more of their money from the bank to interest-bearing securities like government bonds, incurring significant transaction costs.

Costs of Unexpected Inflation

Unexpected inflation can be more costly than expected inflation. When inflation is higher than anticipated, borrowers benefit at the expense of lenders, as the real value of their borrowing declines. For example, if the real interest rate is 2% and you expect inflation to be 2.5% with no uncertainty, you’d be fine with lending your money for a 4.5% nominal interest rate if it’s risk-free. However, if actual inflation turns out to be 10%, you would be displeased as the interest you get doesn’t fully compensate for the diminished purchasing power. The borrower, on the other hand, would be happy as the principal they return is worth less in terms of purchasing power than when they borrowed it.

EXAMPLE: Recall the Fisher effect where we learned that the nominal interest rate is the real interest rate plus expected inflation plus a risk premium? Another cost associated with unexpected inflation is that if inflation is very uncertain or volatile, then lenders will ask for a higher risk premium to compensate for this uncertainty. As a result, borrowing costs will be higher for businesses. Higher borrowing costs could reduce economic activity, as businesses cut back on making investments.

It is also possible that inflation uncertainty can exacerbate the economic cycle. Suppose that when expected inflation is 2.5%, a manufacturer sees that prices for his product have increased by 6%. If this is interpreted as an increase in demand for the product, the manufacturer will increase capacity and production in response to the perceived increase in demand. If, in fact, general price inflation is 6% rather than the expected 2.5% over the recent period, the price increase was actually fully due to inflation rather than demand. Without the increase in demand, the expansion of production will result in excess inventory and capacity, and the firm will decrease production. The firm may have to lay off workers and reduce capital expenditure. Because of these effects, unexpected inflation can increase the magnitude or frequency of business cycles.

Costs of Inflation: Summary

In summary, we’ve learned that expected inflation can give rise to:

• Menu costs
• Shoe leather costs
• Opportunity costs of holding cash

Unexpected inflation can additionally lead to:

• Inequitable transfers of wealth between borrowers and lenders
• Higher risk premiums in borrowing rates
• Reduced information content of market prices

And that concludes this lesson on expected and unexpected inflation. Up next, we’ll learn about the roles of the central bank and the desirable qualities of a central bank.