Ahh, the good old days. Remember those? A gallon of gas used to be a quarter. If you found a dollar on the street you could take your friend out to that great new movie Gentlemen Prefer Blondes (yes, that was an actual movie back in the day), buy “soda pop” and popcorn and still have a dime left over to buy an ice cream on the way home. Remember? No? Well, that’s probably because the year was 1953, and we have had 59 years of inflation since.
Inflation simply refers to the decrease in the purchasing value of a dollar over time. For example, with the 3 percent inflation rate in 2011, a bag of chips sold by Universal Chip Distributor (UCD) that used to cost you $1 now costs you $1.03. That same dollar no longer bought you the same amount of goods or went as far as it used to.
There is no universal agreement on what really causes inflation, but there are two theories that are most accepted. The first is called Cost-Push inflation. When the costs of running a business increase, the business needs to increase its prices to maintain the same level of profit. If UCD experiences an increase in the cost of running their factory, that burden then gets passed off to the student. Er, consumer.
The second theory is called Demand-Pull inflation. This can be summarized by the phrase “too much money chasing too few goods.” As the government prints more and more money to pay off our now over $15 trillion debt, the costs of goods rise. This can be seen using the Quantum theory of money MV=PY where M is the money supply, V is the Velocity of circulation (how often money changes hands), P is the Price level, and Y is the National Income. We can see that if M increases and V and Y remain the same, prices will have to increase to keep the equation balanced.
So how does this all come back to interest rates? Well, it all starts with a common misconception. Almost everyone thinks that inflation is a bad thing, but this isn’t really the case. Inflation affects people in different ways and some people actually benefit from inflation. Let’s make a ridiculous assumption that between the time you were a first-year and senior in college you saw your tuition increase by almost 100 percent, and as a result had to take out student loans. Preposterous, I know, but humor me.
Let’s keep things really simple and imagine you needed to take out a $10,000 loan for one year, knowing you’ll be able to pay it off with that great job you have lined up after graduating. Assume you are charged a 3 percent interest rate. As we know, this means that a year from when you receive the money you will owe $10,300. Now, lets factor in inflation and imagine that for whatever reason, inflation jumped to 5 percent in that same time period. This means that the $10,000 you got is actually worth $10,500 a year from when you received it. As a result of inflation, you didn’t just get an interest-free loan; the bank essentially paid you $200 to hold onto their money for a year. Not a bad gig.
What really matters is whether inflation is anticipated or not. If that bank had known that inflation was going to jump to 5 percent, they would have charged you something like 8 percent on your loan, which would have then given them an effective interest rate of 3 percent. Where the borrower gets screwed is when inflation is overestimated. Imagine inflation was predicted to be 5 percent but is actually 1 percent. You’re then stuck paying 7 percent interest. Good for lenders, problematic for borrowers.
The larger problems occur when inflation is unanticipated or overestimated, which hurts the economy for a variety of reasons. The biggest losses occur when uncertainty about the future causes consumers to spend less. From our equation earlier, MV=PY, we can see that if everything else remains the same, less spending results in a lower national income, and nobody wants that.
If you’d like to talk to DANNY BRAWER about V, Y or any other letters of the alphabet, contact him at dabrawer@ucdavis.edu.
