Skip to main content

Inflation, effects, inflation-free rate

Short answer

Inflation is a continuing rise in general prices, reducing money's purchasing power. Effects include falling real savings, higher interest rates, rising project costs, wealth transfer from lenders to borrowers, and harm to fixed-income groups. Implied inflation-free rate i' = (i - f)/(1+f) = (0.13-0.05)/1.05 = 7.62% per year.

Define inflation. List out its effects. If the inflation rate is 5% per year and the market interest rate is 13% per year, what is the implied interest (inflation free) rate in inflationary economy?

Inflation

Inflation is a continuing rise in the general level of prices of goods and services, so that a unit of money buys less over time.

Effects of inflation

  • Purchasing power of money and the real value of savings fall.
  • Interest rates rise, and the cost of borrowing and projects increases.
  • Costs of materials, labour and equipment rise, so budgets are exceeded.
  • Wealth is transferred from lenders to borrowers who repay in cheaper money.
  • Fixed-income groups (pensioners, salaried people) are hurt; planning for long-lived projects becomes more uncertain.
  • Revenues from fixed-price contracts lose real value.

Implied inflation-free rate

Market rate i = 13%, inflation f = 5%:

i = i' + f + i'f   →   i' = (i − f)/(1 + f)
i' = (0.13 − 0.05)/(1 + 0.05) = 0.08/1.05 = 7.62%

Answer: The implied inflation-free interest rate is 7.62% per year.

✓ Answer checked by Claude Opus 5.5 (high effort)

Related questions

All Engineering Economics chapter 8 questions →