Unexpected Inflation

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  • Topic: Tax, Pension, Redistribution
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Unexpected Inflation and Redistribution of Wealth in Canada Césaire A. Meh, Canadian Economic Analysis, and Yaz Terajima, Financial Stability

One of the most important arguments in favour of price stability is that unexpected inflation generates changes in the distribution of income and wealth among different economic agents. These redistributions occur because many loans in the economy are specified in fixed-dollar terms. Unexpected inflation redistributes wealth from creditors to debtors by reducing the real value of nominal assets and liabilities. This article quantifies the redistributional effects of unexpected inflation in Canada. To this end, we first provide comprehensive evidence of the nominal assets and liabilities of various economic sectors and household groups. We find that the redistributional effects of unexpected inflation are large even for episodes of low inflation. The main winners are young, middleincome households, who are major holders of fixed-rate mortgage debt, and the government, since inflation reduces the real burden of their debt for both groups. The losers are high-income households and middle-aged, middle-income households that hold long-term bonds and nonindexed pension wealth.

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here is ongoing research on potential refinements to monetary policy regimes in countries with low and stable inflation. In Canada, for example, a systematic review of the current inflationtargeting framework is underway (see the other articles in this issue). An issue that has received relatively less attention is the redistributional effects of unexpected inflation.1 Redistributional effects occur because many savings, investments, and loans in the economy are specified in money terms (i.e., not adjusted for inflation); unexpected inflation therefore redistributes wealth from lenders to borrowers by lowering the real value of nominal assets and liabilities.2 The analysis of these effects may be important since the welfare costs of inflation depend not only on aggregate effects but also on potential redistributional consequences. Our calculations show that, even with an episode of low inflation, the redistribution can be sizable. While this is a wealth transfer from one agent in the economy to another, a sense of who wins and who loses is essential in order to assess transitional costs and potential public support for reform. The goal of this article is to provide insight into the redistributional effects of inflation in Canada. The article is a summary of the recent research of Meh and Terajima (2008).3 The article proceeds as follows. The first section documents nominal assets and liabilities (i.e., financial assets and liabilities that are denominated in Canadian dollars and not fully indexed to inflation) held by different economic sectors and

1 2 . 3

In this article, we focus on inflation that is either unexpected or partially unexpected. If inflation were completely expected, the change in the real value of the nominal claim would be incorporated in the contract. Hence, there would not be any redistribution. On the other hand, lower-than-expected inflation redistributes wealth from borrowers to lenders. Meh and Terajima (2008) build on Doepke and Schneider (2006) who document nominal assets and liabilities in the United States and develop a methodology to compute the redistribution of wealth caused by inflation.

UNEXPECTED INFLATION AND REDISTRIBUTION OF WEALTH IN CANADA BANK OF CANADA REVIEW SPRING 2009

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household groups, while the second part describes the methodology used to compute the redistribution of wealth induced by unexpected inflation. Using this methodology and the documented nominal positions, the third section quantitatively assesses the redistribution of wealth under episodes of low and moderate inflation. The final part of the article concludes.

Nominal Assets and Liabilities
Unexpected inflation generates redistributions because most financial assets and liabilities are specified in money terms....
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