Page 635 - The Principle of Economics

CHAPTER 28 MONEY GROWTH AND INFLATION 651
regardless of inflation. If there is no in- flation, in 20 years the pension will have the same purchasing power that it does today. But if there is an inflation rate of only 3 percent per year, in 20 years your pension will be worth only $5,540 in today’s dollars. Five percent inflation over 20 years will cut your purchasing power to $3,770, and 10 percent will reduce it to a pitiful $1,390. Which of these scenarios is likely? No one knows. Inflation ultimately depends on the people who are elected and ap- pointed as guardians of our money supply.
At a time when Americans are liv- ing longer and planning for several decades of retirement, the insidious ef- fects of inflation should be of serious concern. For this reason alone, the cre- ation of inflation-indexed bonds, with their guarantee of a safe return over long periods of time, is a welcome de- velopment.
No other investment offers this kind of safety. Conventional govern- ment bonds make payments that are fixed in dollar terms; but investors should be concerned about purchasing
power, not about the number of dollars they receive. Money market funds make dollar payments that increase with inflation to some degree, since short-term interest rates tend to rise with inflation. But many other factors also influence interest rates, so the real income from a money market fund is not secure.
The stock market offers a high rate of return on average, but it can fall as well as rise. Investors should remem- ber the bear market of the 1970s as well as the bull market of the 1980s and 1990s.
Inflation-indexed government bonds have been issued in Britain for 15 years, in Canada for five years, and in many other countries, including Aus- tralia, New Zealand, and Sweden. In Britain, which has the world’s largest in- dexed-bond market, the bonds have of- fered a yield 3 to 4 percent higher than the rate of inflation. In the United States, a safe long-term return of this sort should make indexed bonds an im- portant part of retirement savings.
We expect that financial insti- tutions will take advantage of the new
inflation-indexed bonds and offer in- novative new products. Indexed-bond funds will probably appear first, but in- dexed annuities and even indexed mort- gages—monthly payments would be adjusted for inflation—should also be- come available. [ Author’s note: Since this article was written, some of these indexed products have been intro- duced, but their use is not yet wide- spread.]
Although the Clinton administration may not get much credit for it today, the decision to issue inflation-indexed bonds is an accomplishment that histo- rians decades hence will single out for special recognition.
SOURCE: The New York Times, May 18, 1996, p. 19.
N A government can pay for some of its spending simply by printing money. When countries rely heavily on this “inflation tax,” the result is hyperinflation.
N One application of the principle of monetary neutrality is the Fisher effect. According to the Fisher effect, when the inflation rate rises, the nominal interest rate rises by the same amount, so that the real interest rate remains the same.
N Many people think that inflation makes them poorer because it raises the cost of what they buy. This view is a fallacy, however, because inflation also raises nominal incomes.
N Economists have identified six costs of inflation: shoeleather costs associated with reduced money holdings, menu costs associated with more frequent adjustment of prices, increased variability of relative prices, unintended changes in tax liabilities due to nonindexation of the tax code, confusion and inconvenience resulting from a changing unit of account, and arbitrary redistributions of wealth between debtors and creditors. Many of these costs are large during hyperinflation, but the size of these costs for moderate inflation is less clear.