Please consider the effect of prices on everything doubling. Suppose all prices
ID: 1194753 • Letter: P
Question
Please consider the effect of prices on everything doubling.
Suppose all prices doubled while you slept. A soft drink that sold for a dollar now
sells for two dollars; a car that sold for $20,000 now sells for $40,000. The price
of labor doubled as well, so a job paying $6 an hour now pays $12; a $30,000
annual salary becomes a $60,000 annual salary.
The value of all assets doubled as well. Stock prices are twice what they were at
yesterday's closing. A $1,000 bond becomes a $2,000 bond. A $35 balance in a
checking account becomes $70, and so on. Debts have also doubled. The $5
borrowed from a roommate becomes $10.The $3000 in
student loans becomes $6000. A $75,000 home mortgage becomes a $150,000
mortgage. And even cash balances double. The inflation fairy sneaks in at night
and replaces the $10 bill in your wallet with a new $20 bill. The inflation fairy
even doubles the coins in your penny jars.
If the prices of everything doubled overnight, what would happen?
Explanation / Answer
If the prices of everything doubled overnight, what would happen: NOTHING.
If all prices adjusted perfectly there would be no real effect. Everyone would have exactly the same purchasing power. They have twice as much money but everything costs twice as much. There have been no relative changes in price.
This is a fantastic rate of inflation: 100% daily. Prices would increase over a billion fold in a month at this rate of price change. Yet, if everything adjusts perfectly there will be no real effect on the economy.
The problem, of course, is there is no inflation fairy ensuring that everything adjusts smoothly. Some prices adjust quickly and others do not.
Cash balances would not double without the inflation fairy, so people would not be willing to hold cash or accept cash in payment. This would increase transaction costs considerably.
If prices do not change at the same rate, there will be winners and losers from inflation. For example, if everything doubled in price overnight except debt, then borrowers would see the real value of their loan payments halved. Borrowers would win and lenders would lose. If the overnight inflation is an ongoing process, everyone would try to borrow, but no one would be willing to lend. Credit markets would collapse.
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