Costs of Inflation: Financial Intermediation Failure

In our earlier video on the cost of inflation, we discussed how unexpected inflation -- it makes price signals noisier. And it encourages mistakes from price confusion and money illusion. Another cost of inflation is that it makes long-term contracting riskier. Suppose that a bank lends $100 at an interest rate of 10%. But suppose also that over the year, the inflation rate is 10%. At the end of the year, the borrower pays back the bank $110. That looks pretty good on paper, but during the year, money has become less valuable. Due to inflation, what used to cost $100 now costs $110.

So, what is the bank's real return? Zero. More generally, we can write that the real interest rate is equal to the nominal rate, the rate charged on paper, minus the inflation rate. Inflation reduces the real return on a loan. So, inflation redistributes wealth from the lender to the borrower. That's exactly what happened in the 1970s in the United States. Suppose, for example, that you had taken out a home mortgage in the 1960s. As a borrower, you'd have done really well, because few people anticipated the high inflation rates of the 1970s.

So, borrowers ended up paying off their mortgages in dollars that were worth less than anyone had expected. Of course, if lenders expect that the inflation rate will be 10% over the coming year, they'll adjust the interest rate that they charge. If the inflation rate is 10% for example, then in order to get a real return of 5%, lenders must charge 15%. More generally, nominal interest rates will rise with expected inflation rates. This is called the Fisher Effect, after the great American economist, Irving Fisher. You can see the Fisher Effect in this data from the United States.

Notice, for example, how interest rates and inflation rates were low in the 1960s, but as inflation increased so did interest rates. Interest rates reached a peak of almost 20% when inflation hit 15% per year. Since that time, inflation has fallen, and so have interest rates. So, suppose instead that you took out a mortgage at an interest rate of 17 or 18% near the peak of inflation around 1981.

What happened next? Unfortunately, for you as a borrower, inflation fell from 15% to less than 5%. You were willing to take out a mortgage at the very high interest rate of 18% per year only because you expected that your wages would be increasing by at least the rate of inflation -- 15% per year. But when inflation is increasing your wages at only 5% per year, the real cost of paying your mortgage is now much higher than you expected. When the interest rate is 18%, and the inflation rate is only 5%, that's a real rate on your loan of 13%. That's a great rate for the lender, but it's a terrible rate for you, the borrower.

So, summarizing, we see that when inflation is higher than expected, wealth is transferred from lenders to borrowers. But when inflation is lower than expected, wealth is transferred from borrowers to lenders. Now, imagine that inflation is high and volatile, so it's difficult to predict whether the inflation rate will go up, or down. As a lender, do you want to lend? No. You fear unexpected increases in inflation. As a borrower, do you want to borrow? No. You fear unexpected decreases in inflation.

So, when inflation is difficult to predict, people fear borrowing and lending. And financial intermediation, the process of moving funds from savers to borrowers, it begins to break down. As inflation heats up, for example, long-term mortgages and long-term lending of all kinds becomes more costly and less common. The economy becomes less able to generate and coordinate savings with investment. And as a result, total wealth declines.

In the next video, we'll look at a final cost of inflation. Once you get started down the inflation path, inflation is very costly to stop.