Price stability can be identified as a low and stable inflation rate. But what are the benefits of price stability? In this segment we focus on the relationship between a low and stable inflation rate and the ability of the populace to maintain stability in the purchasing power of their savings. Inflation is the rate at which the purchasing power of money has dissipated. A high inflation imposes an inflation tax on household to hold currency. On the other hand, investors in interest-earning assets may protect themselves from high inflation by demanding a correspondingly high interest rate. This is called the Fisher effect of inflation on interest rates. However, an unstable inflation rate creates unpredictable real returns for investors who hold interest-earning assets. After viewing this segment, you should be able to, one, calculate the inflation tax; two, identify the long run effect of inflation on interest rates; and, three, calculate the effect of inflation surprises on real returns. Let's get started. According to the central bank of the Philippines, their monetary policy framework hits an inflation that is both low and stable. We can explain the benefits of price stability in terms of the benefits of low and stable inflation. This can be considered in terms of the effect of inflation on interest rates. High inflation will erode the purchasing power of investors' savings. Savers won't just sit still when inflation threatens to eat up their purchasing power, instead they will demand higher interest rates. A useful theory for thinking about the relationship between inflation and interest rates is called the Fisher hypothesis after the early 20th century economist Irving Fisher. Fisher argued that over extended periods, the real interest rate would settle at a level which was unaffected by inflation. Rather, the long-term savings and investment decisions of society would determine the long term real interest rate which we call r star. We might think of this as a structural interest rate. Then, interest rates will be the sum of the structural interest rate in expected future inflation. The implications are clear. When the real interest rate inflation expectations are independent, changes in the trajectory of future inflation will have a one-for-one impact on interest rates. If inflation expectations grow, interest rates will grow and parallel. When inflation expectations decline, so will interest rates. During the 1960s and 1970s, inflation in Japan was much higher than today. Committedly, long-term interest rates were also much higher. Due to oil price shocks, inflation even ran ahead of interest rates for a temporary period. After the late 1970s, changes in monetary policy led to a steady decline in inflation through the 1980s. Long-term interest rates also declined in parallel. In the 1990s, interest rates and inflation moved to unprecedentedly low rates. We do not have good information on long-term bond rates in the Philippines for an extended period. However, we see that inflation has been steadily declining for the last 30 years from around 20 percent per year in the 1980s to around three percent in the current period. We do observe long-term interest rates beginning in the 1990s starting out in double figures but declining over time. Higher interest rates can protect bank depositors and other investors in interest owning assets, but paper currency never pays interest. Real interest rates are the difference between nominal interest rates and inflation. The real interest rates and currency notes is the negative of inflation. Higher inflation reduces the purchasing power of cash holders. High inflation is sometimes referred to as a tax, since it reduces the purchasing power of people who own currency or other non-interest yielding assets. The impact of the inflation tax can be observed in extreme circumstances. Inflation reached extremely high levels in Indonesia during the historical period of the 1960s, reaching a peak in 1966. In that year, inflation was above 1,100 percent. In developing economies, much of household wealth will be held in the form of currency particularly amongst relatively poor and rural people would be more likely to hold their assets in the form of currency rather than interest-earning bank deposits. For example, in 1965 in Indonesia, more than three quarters of liquid wealth was held in the form of currency. When prices went through the roof in that year, many people lost substantial purchasing power from their currency holdings. If the inflation rate was 1,136 percent, then prices in 1966 were more than 12 times as high as in 1965. This means the purchasing power of a unit of currency was lower than one-twelfth after one year. A currency bill that bought one kilo of rice in 1965 would buy 81 grams in 1966. More reasonable levels of inflation would not be as devastating to living standards, but even 10 percent annual inflation would cost you one out of $10 in purchasing power terms, a substantial penalty. We can see the benefit of low inflation. Low inflation maintains the value of currency and leads to low interest rates. But why do we want stable inflation? Remember, we can think of the ex ante real interest rate as expected return on interest-earning assets and purchasing power terms. With 2020 hindsight, we will be able to know what the real return was after the money is repaid. This is the ex post real interest rate. The excess return is the difference between actual and expected return which will be unknown at the time that the investment is made. Saving money has a payoff in terms of purchasing power, but this payoff depends on the realization of inflation over the period of saving. We think of purchasing power risk as a possibility that ex post returns are different than expected at the original time of savings. This is the difference between ex post and ex ante real interest rates. We can derive this unexpected difference as a difference between the actual inflation and expectation. The gap between actual forecasts inflation determines the excess return. Lending money or depositing money has a payoff in terms of purchasing power. This payoff is an unpredictable component which comes from inflation. The unpredictable part comes entirely from unpredictable inflation. Higher than expected inflation means ex post real rates are lower than ex ante. Borrowers are winners and lenders are losers. Lower than expected inflation means ex post real interest rates are higher than ex ante. Borrowers are losers and lenders are winners. Unpredictable inflation creates risk as neither borrowers and lenders will know their true purchasing power return. The Philippines, particularly in the 1970s and 1980s, experienced highly volatile inflation. We did not have a reliable indicator of the public's inflation forecasts during this time period. The simplest proxy may be just to use a moving five year average of past inflation as an indicator of inflation expectations. Using this, we could calculate very extreme outcomes for the gap between actual inflation and expected inflation. There are often years in which the value of the purchasing power of debt assets dropped by double digits in percentage terms. Potential losses of 10 to 20 percent of the purchasing power of an asset in a single year is a substantial risk. The market dislikes risk. At the beginning of the millennium, almost all Philippines government dealt with short-term debt. After reducing inflation risk, the government is able to sell long-term debt. Now that we've completed the segment, you should be able to, one, calculate the inflation tax; two, identify the long-run effect of inflation on interest rates; and, three, calculate the effective inflation surprises on real returns. So what are the benefits of price stability? We have considered the benefits of a low and stable inflation rate. First, real returns are non-interest paying assets like money will be negative when inflation is high. High inflation will create high interest rates on interest-earning assets, but inflation volatility creates purchasing power risk for interest-earning assets. Now that we've learned the benefits of price stability, let's move on to the next segment to thinking about potential causes of inflation instability.