Costs of Inflation: Financial Intermediation Failure

Course Outline

Costs of Inflation: Financial Intermediation Failure

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.

Teacher Resources


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.



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