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Costs of Inflation: Financial Intermediation Failure - YouTube
Channel: Marginal Revolution University
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[Alex] In our earlier video
on the cost of inflation,
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we discussed
how unexpected inflation --
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it makes price signals noisier.
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And it encourages mistakes
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from price confusion
and money illusion.
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Another cost of inflation
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is that it makes
long-term contracting riskier.
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Suppose that a bank lends $100
at an interest rate of 10%.
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But suppose also that over the year,
the inflation rate is 10%.
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At the end of the year,
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the borrower pays back
the bank $110.
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That looks pretty good on paper,
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but during the year,
money has become less valuable.
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Due to inflation, what used
to cost $100 now costs $110.
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So, what is the bank's real return?
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Zero.
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More generally, we can write
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that the real interest rate
is equal to the nominal rate,
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the rate charged on paper,
minus the inflation rate.
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Inflation reduces
the real return on a loan.
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So inflation redistributes wealth
from the lender to the borrower.
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That's exactly what happened
in the 1970s in the United States.
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Suppose, for example,
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that you had taken out
a home mortgage in the 1960s.
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As a borrower,
you'd have done really well,
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because few people anticipated
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the high inflation rates
of the 1970s.
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So, borrowers ended up
paying off their mortgages
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in dollars that were worth less
than anyone had expected.
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Of course, if lenders expect
that the inflation rate will be 10%
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over the coming year,
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they'll adjust the interest rate
that they charge.
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If the inflation rate is 10%
for example,
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then in order to get
a real return of 5%,
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lenders must charge 15%.
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More generally,
nominal interest rates will rise
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with expected inflation rates.
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This is called the Fisher Effect,
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after the great American economist,
Irving Fisher.
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You can see the Fisher Effect
in this data from the United States.
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Notice, for example,
how interest rates
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and inflation rates
were low in the 1960s,
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but as inflation increased
so did interest rates.
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Interest rates reached a peak
of almost 20%
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when inflation hit 15% per year.
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Since that time,
inflation has fallen,
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and so have interest rates.
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So, suppose instead
that you took out a mortgage
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at an interest rate of 17 or 18%
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near the peak of inflation
around 1981.
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What happened next?
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Unfortunately,
for you as a borrower,
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inflation fell from 15%
to less than 5%.
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You were willing
to take out a mortgage
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at the very high interest rate
of 18% per year
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only because you expected
that your wages would be increasing
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by at least the rate of inflation --
15% per year.
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But when inflation
is increasing your wages
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at only 5% per year,
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the real cost
of paying your mortgage
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is now much higher
than you expected.
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When the interest rate is 18%,
and the inflation rate is only 5%,
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that's a real rate
on your loan of 13%.
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That's a great rate for the lender,
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but it's a terrible rate for you,
the borrower.
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So summarizing,
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we see that when inflation
is higher than expected,
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wealth is transferred
from lenders to borrowers.
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But when inflation is lower
than expected,
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wealth is transferred
from borrowers to lenders.
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Now, imagine that inflation
is high and volatile,
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so it's difficult to predict
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whether the inflation rate
will go up, or down.
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As a lender, do you want to lend?
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No.
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You fear unexpected
increases in inflation.
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As a borrower,
do you want to borrow?
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No.
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You fear unexpected
decreases in inflation.
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So, when inflation
is difficult to predict,
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people fear borrowing and lending.
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And financial intermediation,
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the process of moving funds
from savers to borrowers,
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it begins to break down.
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As inflation heats up, for example,
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long-term mortgages
and long-term lending of all kinds
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becomes more costly
and less common.
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The economy becomes less able
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to generate and coordinate
savings with investment.
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And as a result,
total wealth declines.
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In the next video, we'll look
at a final cost of inflation.
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Once you get started
down the inflation path,
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inflation is very costly to stop.
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[Narrator] You're on your way
to mastering economics.
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Make sure this video sticks
by taking a few practice questions.
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Or, if you're ready
for more macroeconomics,
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click for the next video.
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Still here?
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Check out Marginal Revolution
University's other popular videos.
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