Page 180 - Krugmans Economics for AP Text Book_Neat

would have a year earlier. But U.S. tax law would say that the business made a capital
The nominal interest rate is the interest
gain of $10,000, and it would have to pay taxes on that phantom gain.
rate actually paid for a loan.
During the 1970s, when the United States had a relatively high inflation rate, the
The real interest rate is the nominal
distorting effects of inflation on the tax system were a serious problem. Some busi-
interest rate minus the rate of inflation.
nesses were discouraged from productive investment spending because they found
themselves paying taxes on phantom gains. Meanwhile, some unproductive invest-
ments became attractive because they led to phantom losses that reduced tax bills.
When the inflation rate fell in the 1980s—and tax rates were reduced—these problems
became much less important.

Winners and Losers from Inflation
As we’ve just learned, a high inflation rate imposes overall costs on the economy. In
addition, inflation can produce winners and losers within the economy. The main rea-
son inflation sometimes helps some people while hurting others is that economic
transactions, such as loans, often involve contracts that extend over a period of time
and these contracts are normally specified in nominal—that is, in dollar—terms. In the
case of a loan, the borrower receives a certain amount of funds at the beginning, and
the loan contract specifies how much he or she must repay at some future date. But
what that dollar repayment is worth in real terms—that is, in terms of purchasing
power—depends greatly on the rate of inflation over the intervening years of the loan.
The interest rate on a loan is the percentage of the loan amount that the borrower must
pay to the lender, typically on an annual basis, in addition to the repayment of the loan
amount itself. Economists summarize the effect of inflation on borrowers and lenders by
distinguishing between nominal interest rates and real interest rates. The nominal inter-
est rate is the interest rate that is actually paid for a loan, unadjusted for the effects of in-
flation. For example, the interest rates advertised on student loans and every interest rate
you see listed by a bank is a nominal rate. The real interest rate is the nominal interest
rate adjusted for inflation. This adjustment is achieved by simply subtracting the infla-
tion rate from the nominal interest rate. For example, if a loan carries a nominal interest
rate of 8%, but the inflation rate is 5%, the real interest rate is 8% − 5% = 3%.
When a borrower and a lender enter into a loan contract, the contract normally
specifies a nominal interest rate. But each party has an expectation about the future
rate of inflation and therefore an expectation about the real interest rate on the loan. If
the actual inflation rate is higher than expected, borrowers gain at the expense of
lenders: borrowers will repay their loans with funds that have a lower real value than
had been expected—they can purchase fewer goods and service than expected due to the
surprisingly high inflation rate. Conversely, if the inflation rate is lower than expected,
lenders will gain at the expense of borrowers: borrowers must repay their loans with
funds that have a higher real value than had been expected.
Historically, the fact that inflation creates winners and losers has sometimes been a
major source of political controversy. In 1896 William Jennings Bryan electrified the Dem-
ocratic presidential convention with a speech in which he declared, “You shall not crucify
mankind on a cross of gold.” What he was actually demanding was an inflationary policy.
At the time, the U.S. dollar had a fixed value in terms of gold. Bryan wanted the U.S. gov-
ernment to abandon the gold standard and print more money, which would have raised
the level of prices and, he believed, helped the nation’s farmers who were deeply in debt.
In modern America, home mortgages (loans for the purchase of homes) are the
most important source of gains and losses from inflation. Americans who took out
mortgages in the early 1970s quickly found their real payments reduced by higher -
than -expected inflation: by 1983, the purchasing power of a dollar was only 45% of
what it had been in 1973. Those who took out mortgages in the early 1990s were not so
lucky, because the inflation rate fell to lower -than-expected levels in the following
years: in 2003 the purchasing power of a dollar was 78% of what it had been in 1993.
Because gains for some and losses for others result from inflation that is either
higher or lower than expected, yet another problem arises: uncertainty about the future

138 section 3 Measurement of Economic Performance