Main content
Course: Macroeconomics > Unit 4
Lesson 2: Nominal v. real interest rates- Real and nominal return
- Calculating real return in last year dollars
- Nominal interest, real interest, and inflation calculations
- Relation between nominal and real returns and inflation
- Indexing and its limitations
- Lesson summary: nominal vs. real interest rates
- Nominal vs. real interest rates
© 2024 Khan AcademyTerms of usePrivacy PolicyCookie Notice
Indexing and its limitations
How do we adjust for inflation?
Key points
- A payment is said to be indexed if it is automatically adjusted for inflation.
- An adjustable-rate mortgage is a loan used to purchase a home in which the interest rate varies with market interest rates.
- Cost-of-living adjustments are a contractual provision that wage increases will keep up with inflation.
Indexing and its limitations
When a price, wage, or interest rate is adjusted automatically with inflation, it is said to be indexed. An indexed payment increases according to the index number that measures inflation.
A wide array of indexing arrangements is observed in private markets and government programs. Since the negative effects of inflation depend in large part on having inflation unexpectedly affect one part of the economy but not another—say, increasing the prices that people pay but not the wages that workers receive—indexing can take some of the sting out of inflation.
Indexing in private markets
In the 1970s and 1980s, labor unions commonly negotiated wage contracts that had cost-of-living adjustments, or COLAs, which guaranteed that their wages would keep up with inflation. These contracts were sometimes written as, for example, COLA plus 3%. Thus, if inflation were 5%, the wage increase would automatically be 8%, but if inflation rose to 9%, the wage increase would automatically be 12%. COLAs are a form of indexing applied to wages.
Loans often have built-in inflation adjustments too so that, if the inflation rate rises by two percentage points, the interest rate charged on the loan rises by two percentage points as well. An adjustable-rate mortgage, or ARM, is a kind of loan used to purchase a home in which the interest rate varies with the rate of inflation. Often, a borrower will be able receive a lower interest rate if borrowing with an ARM, compared to a fixed-rate loan. The reason is that with an ARM, the lender is protected against the risk that higher inflation will reduce the real loan payments, so the risk premium part of the interest rate can be correspondingly lower.
A number of ongoing or long-term business contracts also have provisions that prices will be adjusted automatically according to inflation. Sellers like such contracts because they are not locked into a low nominal selling price if inflation turns out higher than expected; buyers like such contracts because they are not locked into a high buying price if inflation turns out to be lower than expected. A contract with automatic adjustments for inflation in effect agrees on a real price to be paid, rather than a nominal price.
Indexing in government programs
Many government programs are indexed to inflation. The US income tax code is designed so that as a person’s income rises above certain levels, the tax rate on the marginal income earned rises as well; this is what is meant by the expression “move into a higher tax bracket”. For example, according to the basic tax tables from the Internal Revenue Service, in 2014 a single person owed 10% of all taxable income from $0 to $9,075; 15% of all income from $9,076 to $36,900; 25% of all taxable income from $36,901 to $89,350; 28% of all taxable income from $89,351 to $186,350; 33% of all taxable income from $186,351 to $405,100; 35% of all taxable income from $405,101 to $406,750; and 39.6% of all income from $406,751 and above.
Because of the many complex provisions in the rest of the tax code, the taxes owed by any individual cannot be exactly determined based on these numbers, but the numbers illustrate the basic theme that tax rates rise as the marginal dollar of income rises. Until the late 1970s, if nominal wages increased along with inflation, people were moved into higher tax brackets and owed a higher proportion of their income in taxes, even though their real income had not risen. This bracket creep, as it was called, was eliminated by law in 1981. Now, the income levels where higher tax rates kick in are indexed to rise automatically with inflation.
The Social Security program offers two examples of indexing. Since the passage of the Social Security Indexing Act of 1972, the level of Social Security benefits increases each year along with the Consumer Price Index. Also, Social Security is funded by payroll taxes, which are imposed on the income earned up to a certain amount—$117,000 in 2014. This level of income is adjusted upward each year according to the rate of inflation so that the indexed rise in the benefit level is accompanied by an indexed increase in the Social Security tax base.
And yet another example of a government program affected by indexing—in 1996 the US government began offering indexed bonds. Bonds are the means by which the US government—and many private-sector companies as well—borrow money. Investors buy the bonds, and then the government repays the money with interest. Traditionally, government bonds have paid a fixed rate of interest. This policy gave a government that had borrowed an incentive to encourage inflation because it could then repay its past borrowing in inflated dollars at a lower real interest rate. But indexed bonds promise to pay a certain real rate of interest above whatever inflation rate occurs. In the case of a retiree trying to plan for the long term and worried about the risk of inflation, for example, indexed bonds that guarantee a rate of return higher than inflation—no matter the level of inflation—can be a very comforting investment.
Might indexing reduce concern over inflation?
Indexing may seem like an obviously useful step. After all, when individuals, firms, and government programs are indexed against inflation, then people can worry less about arbitrary redistributions and other effects of inflation.
However, some of the fiercest opponents of inflation express grave concern about indexing. They point out that indexing is always partial. Not every employer will provide COLAs for workers. Not all companies can assume that costs and revenues will rise in lockstep with the general rates of inflation. Not all interest rates for borrowers and savers will change to match inflation exactly. But as partial inflation indexing spreads, the political opposition to inflation may diminish. After all, older people whose Social Security benefits are protected against inflation or banks that have loaned their money with adjustable-rate loans no longer have as much reason to care whether inflation heats up.
In a world where some people are indexed against inflation and some are not, financially savvy businesses and investors may seek out ways to be protected against inflation, while the financially unsophisticated and small businesses may suffer from it most.
A preview of policy discussions of inflation
This tutorial focused on how inflation is measured, historical experience with inflation, how to adjust nominal variables into real ones, how inflation affects the economy, and how indexing works. The causes of inflation have barely been hinted at, and government policies to deal with inflation have not been addressed at all. These issues will be taken up in depth in other tutorials. But a small preview might be helpful now.
The cause of inflation can be summed up in one sentence: Too many dollars chasing too few goods. The great surges of inflation early in the 20th century came after wars, which are a time when government spending is very high but consumers have little to buy because production is going to the war effort. Governments also commonly impose price controls during wartime. After the war, the price controls end and pent-up buying power surges forth, driving up inflation. On the other hand, if too few dollars are chasing too many goods, then inflation will decline or even turn into deflation. Therefore, slowdowns in economic activity, such as major recessions and the Great Depression, are typically associated with a reduction in inflation or even outright deflation.
If inflation is to be avoided, the amount of purchasing power in the economy must grow at roughly the same rate as the production of goods. Macroeconomic policies that the government can use to affect the amount of purchasing power—through taxes, spending, and regulation of interest rates and credit—can thus cause inflation to rise recede to lower levels.
Summary
- A payment is said to be indexed if it is automatically adjusted for inflation.
- An adjustable-rate mortgage is a loan used to purchase a home in which the interest rate varies with market interest rates.
- Cost-of-living adjustments are a contractual provision that wage increases will keep up with inflation.
Self-check questions
How will an increase in inflation affect the interest rate on an adjustable-rate mortgage?
A fixed-rate mortgage has the same interest rate over the life of the loan, whether the mortgage is for 15 or 30 years. By contrast, an adjustable-rate mortgage changes with market interest rates over the life of the mortgage. If inflation falls unexpectedly by 3%, what would likely happen to a homeowner with an adjustable-rate mortgage?
Review questions
- What is indexing?
- Name several forms of indexing in the private and public sector.
Critical-thinking questions
- If a government gains from unexpected inflation when it borrows, why would it choose to offer indexed bonds?
- Do you think perfect indexing is possible? Why or why not?
Problems
Problem one
If inflation rises unexpectedly by 5%, would each of the following economic actors be helped, hurt, or unaffected:
- A union member with a COLA wage contract
- Someone with a large stash of cash in a safe deposit box
- A bank lending money at a fixed rate of interest
- A person who is not due to receive a pay raise for another 11 months
Problem two
Rosalie the retiree knows that when she retires in 16 years, her company will give her a one-time payment of $20,000. However, if the inflation rate is 6% per year. How much buying power will her $20,000 have when measured in today’s dollars? Hint: Start by calculating the rise in the price level over the 16 years.
Want to join the conversation?
How and why inflation can enhance purchasing power?(3 votes)
In Inflation the prices of goods increase rapidly and hence it forces you to buy less i.e cut your purchasing power suppose now a kit kat bar costs 1 dollar after inflation it will cost 2 dollars per piece but since your mom as earlier gave you 1 dollar only you are forced to buy only one bar today.
Hence to sum up Inflation decreases your purchasing power rather than enhancing it(2 votes)
If a government gains from unexpected inflation when it borrows, why would it choose to offer indexed bonds?
Ans:- Is it because they want to improve their credibility, to prove that they wont be reckless and to attract capital at little lower than fixed rate bonds since offering inflation protection ?
Someone please tell me if its true or there is another reason ?(3 votes)
I would also think the same reason as business cited above: that fluctuations in inflation can hurt both parties in an investment. The government, with indexed bonds, is simply making a fair deal that'll yield both the investor and the government what they need.
The government can't always control inflation in the economy and an unexpected deflation can cause the government to lose "real" money from bonds, since deflation usually ensues a recession, the government would like to be able to spend money to create public jobs and increase consumer spending.(3 votes)
Would all of this be the same for different countries?(0 votes)