In the previous video, we learned that inflation can add noise to price signals resulting in some costly mistakes from price confusion and money illusion. Now, we’ll look at how it can interfere with long-term contracting with financial intermediaries.
Let’s say you want to take out a big loan, such as a mortgage on a house. The financial intermediary (in this case, a commercial bank) is going to charge you an interest rate as their profit for loaning you the money. In this situation, inflation has the potential to work against you or it can work against the bank.
If the bank charges you a nominal interest rate (i.e., the interest rate on paper before taking inflation into account) of 5% and inflation climbs unexpectedly to 10% for the year, the real interest rate (nominal minus inflation) falls to -5%. The bank actually loses money. However, if inflation has been higher and banks are charging 15% for mortgages and inflation rates fall unexpectedly to 3%, you’re stuck paying a real interest rate of 12%!
The above scenarios are similar to what actually happened in the United States in the 1960s and 1970s. Inflation was low in the 60s. But then in 70s, inflation rates climbed up unexpectedly. People that purchased a home in the 60s lucked out with low interest rates on their mortgages coupled with higher inflation, and many were able to pay off the loans more quickly than expected. But anyone that purchased a higher interest rate mortgage in the 70s only saw inflation fall back down. It was good for the banks and a costly choice for the homeowners. They were saddled with a high-interest mortgage while lower inflation meant a lower increase in wages.
It’s not that the people buying homes in the 1960s were smarter than those in the 70s. As we’ve noted in previous videos, inflation can be very difficult to predict. When banks expect that inflation might be 10% in the coming years, they will generally adjust their nominal interest rates in order to achieve the desired real interest rate. This relationship between real and nominal interest rates and inflation is known as the Fisher effect, after economist Irving Fisher.
We can see the Fisher effect in the data for nominal interest rates on U.S. mortgages from the 1960s through today. As inflation rates rise, nominal interest rates try to keep up. And as the inflation rates fall, nominal interest rates trail behind.
Now, if inflation rates are both high and volatile, lending and borrowing gets scary for both sides. Long-term contracts like mortgages become more costly for everyone with much higher risk, so it happens less. This is damaging for an economy. Coordinating saving and investment is an important function of the market. If high and volatile inflation is making that inefficient and less common, total wealth declines.
Up next, we’ll explore why governments create inflation in the first place.
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