Business Courses/College Macroeconomics: Homework Help ResourceCourse
- AuthorEdith Forsyth
Edith Forsyth has taught High School Business for over five years. They have a bachelor’s degree in business administration from University of Evansville, Evansville, Indiana.
View bio - InstructorBrianna Whiting
Brianna has a masters of education in educational leadership, a DBA business management, and a BS in animal science.
View bio
Learn about unanticipated inflation and understand how it occurs. Compare the advantages and disadvantages and see who benefits from unanticipated inflation.Updated: 11/21/2023
Table of Contents
- What is Unanticipated Inflation?
- Unanticipated Inflation Example
- Lesson Summary
Frequently Asked Questions
What are the effects of unanticipated deflation?
One of the effects of unanticipated deflation is that it causes a recession. This can be seen in the case of Japan in the 1990s, where they experienced an economic collapse following their stock market crash.
What is anticipated and unanticipated inflation?
Anticipated inflation occurs when consumers expect higher prices for goods and services in the future, which causes them to buy now before prices go up. Unanticipated inflation occurs when an unexpected event increases demand for goods and services beyond what can be met by producers, causing prices to rise faster than expected.
What is an example of unanticipated inflation?
An example of unanticipated inflation is when a country experiences inflation because of natural disasters or economic instability. The country will experience higher prices for goods and services, which people may find difficult to afford.
Table of Contents
- What is Unanticipated Inflation?
- Unanticipated Inflation Example
- Lesson Summary
Inflation is a broad metric for measuring the overall increase in commodity prices. Specifically, it refers to the rate of price increase over a given period. The two types of price increases are anticipated and unanticipated inflation. This lesson focuses on unanticipated inflation.
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What is unanticipated inflation? As consumers, we understand that goods and services have prices we must pay to receive. Sometimes, we do not know that the price will increase, leaving us unprotected. When this happens, it is called unanticipated inflation. Unanticipated inflation occurs when consumers are unaware of an impending increase in market prices. Also known as unexpected inflation, it results in unforeseen changes to purchasing power and financial expectations. For example, when people lend or borrow money, they decide based on the expected inflation rate. However, when this inflation rate differs from expectations, the interest payable or earned will differ from anticipations. As such, it redistributes wealth from lenders to borrowers by reducing the value of money.
What best describes why inflation occurs? Generally, inflation works subject to changes in costs and demand. An increase in production costs such as wages and raw materials or a surge in market demand for goods and services can initiate inflation.
Anticipated Inflation vs. Unanticipated Inflation
It is important to differentiate between anticipated and unanticipated inflation. What is the difference between the two? While unexpected inflation occurs unbeknown to consumers, expected inflation is anticipated based on business cycles. For instance, during recessions, excess production prevents an increase in prices. Another factor that influences anticipated inflation is current and past inflations. Assuming prices have been consistently rising, consumers will expect the prices to continue rising.
In contrast, unanticipated inflation is not expected, steady or predictable. It is unstable and results in a bigger redistribution of wealth and income. Past inflation experiences show that unanticipated inflation redistributes wealth from borrowers to lenders, while anticipated inflation does not benefit any single entity significantly because interest rates and economic expectations are adjusted accordingly.
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What are the advantages of unanticipated inflation? When unexpected inflation occurs, borrowers repay their loans with money that is worth less in terms of the value of goods. However, the costs of unexpected inflation outweigh its benefits. In addition to the typical disadvantages of inflation, such as the reduced value of savings, discouraging investments, and a decrease in real wages, unanticipated inflation arbitrarily redistributes income and wealth. How does this wealth redistribution occur? This type of inflation ensures that the value of goods paid back is less than the value of goods initially borrowed before the inflation, thus redistributing wealth from the lender to the borrower.
Lenders are the worst affected by unanticipated inflation because it reduces the interest value earned from funds loaned out. Households that depend on fixed income also suffer in the case of unexpected inflation.
Positive Effects and Negative Effects
One positive effect of unanticipated inflation is that it benefits employees and borrowers. Employees with increasing income do not suffer the negative consequences of a fixed income. Furthermore, debtors benefit from unexpected inflation because they save money on existing loans. In this case, borrowers are impacted positively.
On the opposite end of the spectrum, unexpected inflation negatively affects purchasing power. For example, retired people experience financial losses on their income and savings due to reduced purchasing power. In this case, their income and savings may not be sufficient enough to cover expenses due to the reduced value. Creditors are adversely affected in case of unanticipated inflation. Banks and other lending institutions get paid back with money that has reduced purchasing power, resulting in financial losses. In the long run, lenders are negatively impacted by unanticipated inflation.
Who Benefits from Unanticipated Inflation?
The primary beneficiaries of unanticipated inflation are people who borrowed money before inflation. For example, someone looking to take out a loan will benefit because the real interest they pay back will be less than stipulated in their loan obligation. The arithmetic calculation in the next section provides a good example showing how real interest rate changes during an unanticipated inflation.
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An arithmetical unanticipated inflation example demonstrates the concept of unanticipated inflation. Suppose an individual looks to take out a loan of $1000 and agrees to repay in five years at an interest rate of 5%. A simple calculation shows that when the loan is due, the borrower is expected to repay;
$1000 (1 + r) n = $1000 (1.05)5 = $1276.28.
Where r = Interest Rate
n = Repayment Period
However, assume that within five years, price levels double due to unexpected inflation. In such a scenario, the debtor will pay back half the amount of goods initially borrowed because the dollar's real value will be half. Therefore, the borrower will repay only $638.14 (valued in terms of goods) in real terms. From the debtor's point of view, this is savings because despite borrowing $1000 worth of goods, they will repay only $638.14. To find the real interest rate repaid, we substitute the actual amount repaid into the formula;
A0 = A1 / (1 + r) n
Where A0 = Initial loan
A1 = Actual amount repaid
r = Interest rate
n = Repayment period
Thus;
{eq}1000 =\frac{638.14}{1 + r}^5 {/eq}
{eq}r = [{\frac{638.14}{1000}}]^{{\frac{1}{5}}} - 1 = -0.085 {/eq}
The calculation above suggests that although the interest rate at the time of borrowing was 5%, the lender will pay the borrower an interest rate of 8.5%. In this unanticipated inflation example, unexpected inflation has redistributed wealth from the lender to the borrower. Indeed, borrowers are the least likely to be hurt by unanticipated inflation.
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The overall increase in market prices is measured in terms of inflation. Consumers expect anticipated inflation based on business cycles, while unanticipated inflation is not foreseen. In the case of unanticipated inflation, wealth is redistributed from lenders to borrowers. This arbitrary redistribution results from changes in purchasing power and real interest rates. A key advantage of unexpected inflation is that it increases borrowers' savings because they repay their loans with money that has reduced purchasing power, as shown in the unanticipated inflation example. While it positively affects borrowing, unexpected inflation negatively affects lenders and individuals on a fixed income.
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Video Transcript
What Is Unanticipated Inflation?
As a consumer, we are all aware that goods have a price that we are expected to pay in order to receive them. While we are always looking for a great deal, what would happen if there was not a deal to be found because the general level for the price of goods kept increasing? Would you buy the goods anyway, or would you wait to purchase the goods? This is the general concept for inflation, and when this happens unexpectedly, it is known as unanticipated inflation.
So you may be asking yourself, what exactly is inflation, and does inflation always occur unexpectedly? First, inflation is an increase in the general price level of goods that continues to increase. Second, inflation does not always happen unexpectedly. In fact, inflation can be both unanticipated and anticipated. However, in order to fully understand unanticipated inflation, we must differentiate it from anticipated inflation.
Anticipated inflation occurs when people know inflation is going to occur and prepare for it. For example, increased interest rates; if inflation is anticipated, banks can try and protect themselves by increasing the interest rates. Unanticipated inflation occurs when people do not know inflation is going to occur until after the general price level increases. When this happens, many individuals are left unprotected, such as lenders who get paid back with a money that has a reduced purchasing power.
Positive and Negative Effects
Now that we know what unanticipated inflation is and how it differs from anticipated inflation, let's look at the effects.
Negative Effects
When inflation occurs unexpectedly, those on a fixed income, such as retired individuals, often encounter losses. Because those on a fixed income don't, or can't, get an increase in their pay, the money they do receive is often not enough to live on or cover expenses since a dollar now has less value. Banks who give out loans also become negatively affected because they get paid back with a dollar that has a lower purchasing power.
Positive Effects
Those that benefit from unanticipated inflation are employees with increasing income and individuals with debt. Unlike banks, debtors paying with a dollar that has a decreased purchasing power, save money on their loans.
In the end, both anticipated and unanticipated inflation tend to cause uncertainty for many people and businesses. How should one spend his money, what should one invest in, and what will prices, profits, and costs be in the future, are all concerns in the face of inflation and can lead to a reduction in economic growth.
Example
So how can unanticipated inflation be applied in real life? Let's take a look at an example.
The Shoe Company is a shop that produces shoes for all ages. During unanticipated inflation, the company often benefits greatly. You see, when inflation occurs unexpectedly, the price for goods goes up. This means that The Shoe Company sees greater profits because they are getting paid more for their products. The rise in profits is coupled with wages that have not gone up to match the higher cost consumers now have to pay for these products. So, for a period of time before wages begin to rise to make up for the increase in products, The Shoe Company can expect to see greater profits when unanticipated inflation occurs.
Lesson Summary
Let's review. While inflation can cause problems for various individuals and businesses, often it is how the inflation occurs that determines who will be affected the most and how.
Unanticipated inflation occurs when the general price level changes unexpectedly. Those who are retired or on a fixed income seem to take the hardest hit, as well as those institutions that offer loans. While it may be a difficult time for banks, borrowers can take advantage of unanticipated inflation in terms of lower rates and paying less on their loans long-term. In the end, when something occurs unexpectedly, there is always a positive and negative aspect to the situation, much like inflation.
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