When an indexed unit of account
is used in contracts, payments are indexed to the price level
in such a way that changes in the inflation rate have no effect on the real value of payments. Non-indexed units, such as contracts written in currency units, incur inflation risk. In periods of unexpectedly high inflation, the debtor is required to pay less in real terms than what both the debtor and creditor agreed to. On the other hand, in periods of unexpectedly low inflation, the debtor is required to pay more in real terms than the agreed value. Contracts in indexed units of account incur no inflation risk, as the real value of payments remains constant.
Indexation is typically achieved by adjusting payments using a consumer price index
. An indexed unit of account, called the Unidad de Fomento
was introduced in Chile in 1967, but it was only in the early 1980s that it was widely adopted by both the Chilean people and the Chilean government. By 1983, over 60 percent of total bank loans in Chile were written in the UF. The value of the UF in pesos is published daily in all major Chilean newspapers and on government websites. Initial doubts about the Chilean governments ability to adopted inflation targeting under such an indexed financial system proved unfounded as the Bank of Chile has successfully maintained low inflation rates since 1998.
In 1848, John Stuart Mill
discusses the inflation risk of non-indexed units of accounts. He states that... Read More