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de the real value of money the functional currency and other items with an underlying monetary nature debtors who have debts with a fixed nominal rate of interest will see a reduction in the real interest rate as the inflation rate rises the real interest on a loan is the nominal rate minus the inflation rate the formula r n i approximates the correct answer as long as both the nominal interest rate and the inflation rate are small the correct equation is r n i where r n and i are expressed as ratios e g 1 2 for 20 0 8 for 20 as an example when the inflation rate is 3 a loan with a nominal interest rate of 5 would have a real interest rate of approximately 2 in fact it s 1 94 any unexpected increase in the inflation rate would decrease the real interest rate banks and other lenders adjust for this inflation risk either by including an inflation risk premium to fixed interest rate loans or lending at an adjustable rate 125 negative edit inflation is illustrated by the contrast between what r 100 could buy in 2010 and in 2022 observed by lula during a meeting with women in brasilândia high or unpredictable inflation rates are regarded as harmful to an overall economy they add inefficiencies in the market and make it difficult for companies to budget or plan long term inflation can act as a drag on productivity as companies are forced to shift resources away from products and services to focus on profit and losses from currency inflation 60 uncertainty about the future purchasing power of money discourages investment and saving 126 inflation hurts asset prices such as stock performance in the short run as it erodes non energy corporates profit margins and leads to central banks policy tightening measures 127 inflation can also impose hidden tax increases for instance inflated earnings push taxpayers into higher income tax rates unless the tax brackets are indexed to inflation with high inflation purchasing power is redistributed from those on fixed nominal incomes such as some pensioners whose pensions are not indexed to the price level towards those with variable incomes whose earnings may better keep pace with the inflation 60 this redistribution of purchasing power will also occur between international trading partners where fixed exchange rates are imposed higher inflation in one economy than another will cause the first economy s exports to become more expensive and affect the balance of trade there can also be negative effects to trade from an increased instability in currency exchange prices caused by unpredictable inflation hoarding people buy durable and or non perishable commodities and other goods as stores of wealth to avoid the losses expected from the declining purchasing power of money creating shortages of the hoarded goods social unrest and revolts inflation can lead to massive demonstrations and revolutions thomas sargent showed how the huge public debt hoarded by louis xvi stimulated the french revolution 128 after the revolution inflation replaced debt as a tool for financing the debt 129 130 the post revolution hyperinflation is considered as one of the reason for the rise of napoleon 131 132 133 likewise the german hyperinflation is considered to be one of the reason for the rise of the nazi party 134 135 inflation and in particular food inflation is considered one of the main reasons that caused the 2010 2011 tunisian revolution 136 and the 2011 egyptian revolution 137 according to many observers including robert zoellick 138 president of the world bank tunisian president zine el abidine ben ali was ousted egyptian president hosni mubarak was also ousted after only 18 days of demonstrations and protests soon spread in many countries of north africa and middle east the high inflation in iran especially of food is considered as one of the main reasons for the 2025 2026 mass protests in iran 139 140 141 hyperinflation if inflation becomes too high it can cause people to severely curtail their use of the currency leading to an acceleration in the inflation rate high and accelerating inflation grossly interferes with the normal workings of the economy hurting its ability to supply goods hyperinflation can lead people to abandon the use of the country s currency in favour of external currencies dollarization as has been reported to have occurred in north korea 142 allocative efficiency a change in the supply or demand for a good will normally cause its relative price to change signaling the buyers and sellers that they should re allocate resources in response to the new market conditions but when prices are constantly changing due to inflation price changes due to genuine relative price signals are difficult to distinguish from price changes due to general inflation so agents are slow to respond to them the result is a loss of allocative efficiency shoe leather cost high inflation increases the opportunity cost of holding cash balances and can induce people to hold a greater portion of their assets in interest paying accounts however since cash is still needed to carry out transactions this means that more trips to the bank are necessary to make withdrawals proverbially wearing out the shoe leather with each trip menu cost with high inflation firms must change their prices often to keep up with economy wide changes but often changing prices is itself a costly activity whether explicitly as with the need to print new menus or implicitly as with the extra time and effort needed to change prices constantly tax inflation serves as a hidden tax on currency holdings 143 144 positive edit labour market adjustments nominal wages are slow to adjust downward this can lead to prolonged disequilibrium and high unemployment in the labor market since inflation allows real wages to fall even if nominal wages are kept constant moderate inflation enables labor markets to reach equilibrium faster 145 room to maneuver the primary tools for controlling the money supply are the ability to set the discount rate the rate at which banks can borrow from the central bank and open market operations which are the central bank s interventions into the bonds market with the aim of affecting the nominal interest rate if an economy finds itself in a recession with already low or even zero nominal interest rates then the bank cannot cut these rates further since negative nominal interest rates are impossible to stimulate the economy this situation is known as a liquidity trap mundell tobin effect according to the mundell tobin effect an increase in inflation leads to an increase in capital investment which leads to an increase in growth 146 the nobel laureate robert mundell noted that moderate inflation would induce savers to substitute lending for some money holding as a means to finance future spending that substitution would cause market clearing real interest rates to fall 147 the lower real rate of interest would induce more borrowing to finance investment in a similar vein nobel laureate james tobin noted that such inflation would cause businesses to substitute investment in physical capital plant equipment and inventories for money balances in their asset portfolios that substitution would mean choosing the making of investments with lower rates of real return the rates of return are lower because the investments with higher rates of return were already being made before 148 the two related effects are known as the mundell tobin effect unless the economy is already overinvesting according to models of economic growth theory that extra investment resulting from the effect would be seen as positive instability with deflation economist s c tsiang noted that once substantial deflation is expected two important effects will appear both a result of money holding substituting for lending as a vehicle for saving 149 the first was that continually falling prices and the resulting incentive to hoard money will cause instability resulting from the likely increasing fear while money hoards grow in value that the value of those hoards are at risk as people realize that a movement to trade those money hoards for real goods and assets will quickly drive those prices up any movement to spend those hoards once started would become a tremendous avalanche which could rampage for a long time before it would spend itself 150 thus a regime of long term deflation is likely to be interrupted by periodic spikes of rapid inflation and consequent real economic disruptions the second effect noted by tsiang is that when savers have substituted money holding for lending on financial markets the role of those markets in channeling savings into investment is undermined with nominal interest rates driven to zero or near zero from the competition with a high return money asset there would be no price mechanism in whatever is left of those markets with financial markets effectively euthanized the remaining goods and physical asset prices would move in perverse directions for example an increased desire to save could not push interest rates further down and thereby stimulate investment but would instead cause additional money hoarding driving consumer prices further down and making investment in consumer goods production thereby less attractive moderate inflation once its expectation is incorporated into nominal interest rates would give those interest rates room to go both up and down in response to shifting investment opportunities or savers preferences and thus allow financial markets to function in a more normal fashion cost of living allowance edit see also cost of living the real purchasing power of fixed payments is eroded by inflation unless they are inflation adjusted to keep their real values constant in many countries employment contracts pension benefits and government entitlements such as social security are tied to a cost of living index typically to the consumer price index 151 a cost of living adjustment cola adjusts salaries based on changes in a cost of living index 152 it does not control inflation but rather seeks to mitigate the consequences of inflation for those on fixed incomes salaries are typically adjusted annually in low inflation economies during hyperinflation they are adjusted more often 151 they may also be tied to a cost of living index that varies by geographic location if the employee moves annual escalation clauses in employment contracts can specify retroactive or future percentage increases in worker pay which are not tied to any index these negotiated increases in pay are colloquially referred to as cost of living adjustments colas or cost of living increases because of their similarity to increases tied to externally determined indexes control of inflation edit monetary policy is the policy enacted by the monetary authorities most frequently the central bank of a nation to accomplish their objectives 153 among these keeping inflation at a low and stable level is often a prominent objective either directly via inflation targeting or indirectly e g via a fixed exchange rate against a low inflation currency area historical approaches to inflation control edit historically central banks and governments have followed various policies to achieve low inflation employing various nominal anchors before world war i the gold standard was prevalent but was eventually found to be detrimental to economic stability and employment not least during the great depression in the 1930s 154 for the first decades after world war ii the bretton woods system initiated a fixed exchange rate system for most developed countries tying their currencies to the us dollar which again was directly convertible to gold 155 the system disintegrated in the 1970s however after which the major currencies started floating against each other 156 during the 1970s many central banks turned to a money supply target recommended by milton friedman and other monetarists aiming for a stable growth rate of money to control inflation however it was found to be impractical because of the unstable relationship between monetary aggregates and other macroeconomic variables and was eventually abandoned by all major economies 154 in 1990 new zealand as the first country ever adopted an official inflation target as the basis of its monetary policy continually adjusting interest rates to steer the country s inflation rate towards its official target the strategy was generally considered to work well and central banks in most developed countries have over the years adapted a similar strategy 157 as of 2023 the central banks of all g7 member countries can be said to follow an inflation target including the european central bank and the federal reserve who have adopted the main elements of inflation targeting without officially calling themselves inflation targeters 157 in emerging countries fixed exchange rate regimes are still the most common monetary policy 158 fixed exchange rates edit main article fixed exchange rate system under a fixed exchange rate currency regime a country s currency is tied in value to another single currency or to a basket of other currencies a fixed exchange rate is usually used to stabilize the value of a currency vis a vis the currency it is pegged to it can also be used as a means to control inflation if the currency area tied to itself maintains low and stable inflation however as the value of the reference currency rises and falls so does the currency pegged to it this essentially means that the inflation rate in the fixed exchange rate country is determined by the inflation rate of the country the currency is pegged to in addition a fixed exchange rate prevents a government from using domestic monetary policy to achieve macroeconomic stability 159 as of 2023 denmark is the only oecd country which maintains a fixed exchange rate against the euro but it is frequently used as a monetary policy strategy in developing countries 158 gold standard edit main article gold standard two 20 krona gold coins from the scandinavian monetary union a historical example of an international gold standard the gold standard is a monetary system in which a region s common medium of exchange is paper notes or other monetary token that are normally freely convertible into pre set fixed quantities of gold the standard specifies how the gold backing would be implemented including the amount of specie per currency unit the currency itself has no innate value but is accepted by traders because it can be redeemed for the equivalent value of the commodity specie a u s silver certificate for example could be redeemed for an actual piece of silver under a gold standard the long term rate of inflation or deflation would be determined by the growth rate of the supply of gold relative to total output 160 critics argue that this will cause arbitrary fluctuations in the inflation rate and that monetary policy would essentially be determined by an 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