INFLATION EXPECTATIONS & THE CREDIT MARKET: A SIMPLE EXAMPLE

Let me briefly clarify the impact of a change in inflation expectations on long-term interest rates in the credit market.

A key assumption, when people expect a higher inflation rate in the future, is that incomes will rise –at least in nominal terms. If you sell goods or services, your prices will rise (remember: inflation means that all prices go up!). As a worker, you will likely obtain at least a nominal compensation (especially if trade unions are strong). It is precisely this expectation that alters the behavior of those who demand credit. A loan at a fixed rate makes a lot of sense if you expect your income to go up!

Example. If somebody expects his or her nominal income to increase by 15% a year (starting at $10,000), while paying a fixed interest rate of 5% $10,000 for a loan, this is how the interest burden would look like:

[1] Expected nominal income: $10,000 (year 1); $11,500 (year 2); $13,225 (year 3)

[2] Interest payments (fixed!): $500 (year 1); $500 (year 2); $500 (year 3)

[3] Expected interest burden: $500/$10,000 (year 1); $500/$11,500 (year 2); $500/$13,225 (year 3)

In others words, the interest burden is expected to decrease every year, because interest payments remain fixed while your income is expected to go up. This is why –when inflation expectations increase- people demand more credit at each level of the interest rate. In Brock’s diagram, the demand schedule (or curve) moves upward and rightward.

But that may too good to be true!

Those who supply loanable resources will react too! Their situation is precisely the opposite. They expect to receive a fixed interest in a currency that will have less purchasing power. Suppose that the cost of a $100 basket of goods is expected to increase by 15% a year, then this is how the real return to the lender would look like (if he or she lends $10,000 at a fixed 5% rate):

[1] Interest income (fixed!): $500 (year 1); $500 (year 2); $500 (year 3)

[2] Expected cost of a basket of goods: $100 (year 1); $115 (year 2); $132.25 (year 3)

[3] Expected purchasing power of interest income: $500/$100 (year 1); $500/$115 (year 2); $500/$132.25 (year 3)

Thus, I would expect that the purchasing power of my interest income will go down each year. In year 1, my $500 income from loans enables me to “buy” 5 baskets; in year 2, it is expected to buy 4.34 baskets, and only 3.78 baskets in year 3. This is why –when inflation expectations increase– those who supply loanable resources will tend to supply less at each level of the interest rate. In Brock’s diagram, the supply schedule (or curve) moves upward and leftward.

To sum up, whenever inflation expectations increase, interest rates in the credit market will rise, because both those who demand credit and those who supply loanable resources adjust their behavior. More demand for credit and less supply always lead to higher interest rates.
____________