When a company borrows money, the money it receives now will be repaid later with money it earns. Inflation, by definition, causes the value of a currency to depreciate over time. In other words, cash today is more valuable than cash afterwards. As a result of inflation, debtors can repay lenders with money that is worth less than it was when they borrowed it.
Is debt increased or decreased by inflation?
Question from a reader: Why does inflation make it easier for governments to repay their debts?
During the 1950s, 1960s, and 1970s, when inflation was quite high, the national debt as a percentage of GDP dropped dramatically. Deflation and massive debt characterized the 1920s and 1930s.
Inflation makes it easier for a government to pay its debt for a variety of reasons, especially when inflation is larger than planned. In conclusion:
- Nominal tax collections rise as inflation rises (if prices are higher, the government will collect more VAT, workers pay more income tax)
- Higher inflation lowers the actual worth of debt; bondholders with fixed interest rates will see their bonds’ real value diminish, making it easier for the government to repay them.
- Higher inflation allows the government to lock income tax levels, allowing more workers to pay higher tax rates thereby increasing tax revenue without raising rates.
Why inflation can benefit the government at the expense of bondholders
- Let’s pretend that an economy has 0% inflation and that people anticipate it to stay that way.
- Let’s say the government needs to borrow 2 billion and sells 1,000 30-year bonds to the private sector. The government may give a 2% annual interest rate to entice individuals to acquire bonds.
- The government will thereafter be required to repay the full amount of the bonds (1,000) as well as the annual interest payments (20 per year at 2%).
- Investors who purchase the bonds will profit. The bond yield (2%) is higher than the inflation rate. They get their bonds back, plus interest.
- Assume, however, that inflation of 10% occurred unexpectedly. Money loses its worth as a result of this. As prices rise as a result of inflation, 1,000 will buy fewer products and services.
- As salaries and prices rise, the government will receive more tax money as a result of inflation (for example, if prices rise 10%, the government’s VAT receipts will rise 10%).
- As a result, inflation aids the government in collecting more tax income.
- Bondholders, on the other hand, lose out. The government still owes only 1,000 in repayment. However, inflation has lowered the value of that 1,000 bond (it now has a real value of 900). Because the inflation rate (ten percent) is higher than the bond’s interest rate (two percent), their funds are losing actual value.
- Because of inflation, repaying bondholders needs a lesser percentage of the government’s overall tax collection, making it easier for the government to repay the original loan.
As a result of inflation, the government (borrower) is better off, whereas bondholders (savers) are worse off.
Evaluation (index-linked bonds)
Some bondholders will purchase index-linked bonds as a result of this risk. This means that if inflation rises, the maturity value and interest rate on the bond will rise in lockstep with inflation, protecting the bond’s real value. The government does not benefit from inflation in this instance since it pays greater interest payments and is unable to discount the debt through inflation.
Inflation and benefits
Inflation is expected to peak at 6.2 percent in 2022 in the United Kingdom, resulting in a significant increase in nominal tax receipts. The government, on the other hand, has expanded benefits and public sector salaries at a lower inflation rate. In April 2022, inflation-linked benefits and tax credits will increase by 3.1%, as determined by the Consumer Price Index (CPI) inflation rate in September 2021.
As a result, public employees and benefit recipients will suffer a genuine drop in income their benefits will increase by 3.1 percent, but inflation might reach 6.2 percent. The government’s financial condition will improve in this case by increasing benefits at a slower rate than inflation.
Only by making the purposeful decision to raise benefits and wages at a slower rate than inflation can debt be reduced.
Inflation and bracket creep
Another approach for the government to benefit from inflation is to maintain a constant income tax level. The basic rate of income tax (20%), for example, begins at 12,501. At 50,000, the tax rate is 40%, and at 150,000, the tax rate is 50%. As a result of inflation, nominal earnings will rise, and more workers will begin to pay higher rates of income tax. As a result, even though the tax rate appears to be unchanged, the government has effectively raised average tax rates.
Long Term Implications of inflation on bonds
People will be hesitant to buy bonds if they expect low inflation and subsequently lose the real worth of their savings due to high inflation. They know that inflation might lower the value of bondholders’ money.
If bondholders are concerned that the government will generate inflation, greater bond rates will be desired to compensate for the risk of losing money due to inflation. As a result, the likelihood of high inflation may make borrowing more onerous for the government.
Bondholders may not expect zero inflation; yet, bondholders are harmed by unexpected inflation.
Example Post War Britain
Inflation was fairly low throughout the 1930s. This is one of the reasons why individuals were willing to pay low interest rates for UK government bonds (in the 1950s, the national debt increased to over 230 percent of GDP). Inflationary effects lowered the debt burden in the postwar period, making it simpler for the government to satisfy its repayment obligations.
In the 1970s, unexpected inflation (due to an oil price shock) aided in the reduction of government debt burdens in a number of countries, including the United States.
Inflation helped to expedite the decline of UK national debt as a percentage of GDP in the postwar period, lowering the real burden of debt. However, debt declined as a result of a sustained period of economic development and increased tax collections.
Economic Growth and Government Debt
Another issue is that if the government reflates the economy (for example, by pursuing quantitative easing), it may stimulate both economic activity and inflation. A higher GDP is a crucial component in the government’s ability to raise more tax money to pay off its debt.
Bondholders may be concerned about an economy that is expected to experience deflation and negative growth. Although deflation might increase the real value of bonds, they may be concerned that the economy is stagnating too much and that the government would struggle to satisfy its debt obligations.
What effect does rising inflation have on the national debt?
Spending cuts of any type are almost as unattractive to lawmakers. Taking away what the electorate considers a “right” or a “entitlement” is the equivalent of ending your political career.
Raising taxes is more palatable, especially in countries where the majority of people do not pay taxes or where the increases only affect “the rich,” as the populace perceives them. The danger is that if taxes are raised too high, the motivation to labor is reduced, and the economy as a whole collapses. As a result, gross tax collections fall, causing the country’s debt crisis to worsen as the government is forced to borrow more to avoid making any spending cuts.
Then there’s inflation. The most politically acceptable method of lowering the debt in a way that is mostly unnoticed by the people is to use sluggish, chronic inflation.
How Does Inflation Reduce Debt?
Because the currency loses value as a result of inflation, the people and institutions who own the debt are the losers. Assume you borrow money from the government by purchasing a $1000 US government bond with a ten-year maturity. You could get a fully loaded laptop or a round trip ticket to London for $1000 at the moment you buy it.
Let’s imagine the United States inflates its currency at a pace of 7% for the next ten years, which is roughly double the “average” inflation rate of 3.3 percent for the previous 80 years. The bond matures at the end of that period, and you receive your $1000 back. You go out to buy a laptop, which now costs $2000. The journey to London was also $2000. Many people in this situation will believe that laptop and airline ticket prices have increased.
In fact, the cost of these things hasn’t increased by a penny in real dollars (dollars adjusted for inflation). In this scenario, the value of the dollar has fallen by 50 percent over ten years. The United States government is the great winner here, as its multitrillion-dollar debt has been cut in half (in real terms) in just ten years. They were able to do so without raising taxes or slashing spending, which politicians find irresistible.
If the country experiences persistent deflation, similar to Japan, where consumer prices have fallen by up to 2% per year over the past 15 years, government revenues will fall while the real value of the country’s large debt will rise, further stalling future growth. It becomes a vicious cycle with few, if any, instruments available to politicians to break it.
As a result, the ideal treatment is progressive inflation. Citizens become like the proverbial frog that is slowly cooked in a pan of water with the temperature gradually increasing, rather than being frozen to death by deflation, when it is done well. Of course, neither outcome is good for the frog in the end.
What happens when prices rise?
Inflation raises your cost of living over time. Inflation can be harmful to the economy if it is high enough. Price increases could be a sign of a fast-growing economy. Demand for products and services is fueled by people buying more than they need to avoid tomorrow’s rising prices.
Who is responsible for the national debt?
Many people believe that much of the US national debt is owing to foreign countries such as China and Japan, but the truth is that the majority of it is owed to US Social Security and pension systems. This means that the majority of the national debt is owned by Americans.
What does debt inflation mean?
Question from the audience: Inflation, I understand, can reduce the value of debt for countries and firms, because higher prices indicate more revenue for the same output, and hence more money to service debt. Does this, however, relate to personal debt? i.e., unless my wages increase in line with inflation, I will have no additional income and will have to pay off my debt with the same (or possibly less) money. Is this what I’m thinking?
You are entirely correct. If your wages/income improve, your personal real debt burden will decrease, making it easier to repay.
If your wages keep up with inflation, inflation might diminish the value of your debt. There can be inflation without an increase in income. It is more difficult to pay off your debt in this situation. Your salary is constant, but you must spend more on purchases, leaving you with less disposable cash to pay down your debt.
In the United Kingdom, inflation usually causes nominal salaries to rise. Wages typically increase faster than inflation. For example, if inflation is 5%, workers may receive a 7% raise.
Obviously, if you owe 1,000 and your nominal pay is increasing at 7% per year, the real value of your debt will decrease.
Interest rates, on the other hand, are an important consideration. Inflationary pressures frequently result in higher interest rates. If you borrow money from a bank, the interest rate will almost certainly be higher than inflation. Despite the fact that the debt’s real worth decreases with inflation, you pay more interest on the loan.
Unexpected Inflation
If you have a debt, having a stable interest rate is preferable than unexpectedly large inflation. This means that the debt’s true value drops unexpectedly, but your interest rate stays the same. (On the other hand, unanticipated inflation is bad news for fixed-interest savers.)
Example Mortgage Debt and Inflation.
Wages have often risen faster than inflation in the postwar period, resulting in an increase in real incomes. Mortgage holders take out a 30-year loan. When they start repaying their mortgage, it consumes a large portion of their earnings. However, as inflation and salaries rise, these mortgage repayments as a percentage of income decrease. It gets much easier to repay their mortgage as time goes on. As a result, growing salaries and inflation help to diminish the value of their debt.
Falling Real Wages
Inflation is running at a faster pace than nominal wage growth in 2010/11. This indicates that actual earnings are decreasing. As a result of the sluggish wage growth, the real value of debt is only reducing by a tiny amount, while living costs are growing.
Currently, bank interest rates are greater than nominal wage growth. As a result, this is not a good moment to take out a loan. Unless you have a tracker mortgage, in which case your mortgage rate is linked to the federal funds rate.
Who is affected by inflation?
Unexpected inflation hurts lenders since the money they are paid back has less purchasing power than the money they lent out. Unexpected inflation benefits borrowers since the money they repay is worth less than the money they borrowed.
Do prices fall as a result of inflation?
The consumer price index for January will be released on Thursday, and it is expected to be another red-flag rating.
As you and your wallet may recall, December witnessed the greatest year-over-year increase since 1982, at 7%. As we’ve heard, supply chain or transportation concerns, as well as pandemic-related issues, are some of the factors pushing increasing prices. Which raises the question of whether prices will fall after those issues are overcome.
The answer is a resounding nay. Prices are unlikely to fall for most items, such as restaurant meals, clothing, or a new washer and dryer.
“When someone realizes that their business’s costs are too high and it’s become unprofitable, they’re quick to identify that and raise prices,” said Laura Veldkamp, a finance professor at Columbia Business School. “However, it’s rare to hear someone complain, ‘Gosh, I’m making too much money.'” To fix that situation, I’d best lower those prices.'”
When firms’ own costs rise, they may be forced to raise prices. That has undoubtedly occurred.
“Most small-business owners are having to absorb those additional prices in compensation costs for their supplies and inventory products,” Holly Wade, the National Federation of Independent Business’s research director, said.
But there’s also inflation caused by supply shortages and demand floods, which we’re experiencing right now. Because of a chip scarcity, for example, only a limited number of cars may be produced. We’ve seen spikes in demand for products like toilet paper and houses. And, in general, people are spending their money on things other than trips.
Why are banks unable to just print additional money?
Money is a necessary component of everyone’s life. It is utilized to purchase everyday necessities and other goods for use and consumption. The money that comes in is what makes a business operation run. People look for work in order to earn money through remuneration. Despite the various options accessible, many people do not have enough money, and poverty continues to persist.
Some people might wonder why the government isn’t making more money. Why not create more bills and distribute them to the poor, given that the Bangko Sentral ng Pilipinas is in charge of money production? Isn’t it true that if everyone has money, poverty will be eradicated? The idea of everyone having enough money to buy anything they need and want seems like a fantastic idea. However, if you ask an economist, he will most likely tell you that it is a bad idea. But why is it that having more money is such a bad idea? Inflation is to blame for everything.
What is Inflation?
Inflation is defined as a steady increase in the price of products over a period of time. It is frequently stated as a percentage change in the rate of increase in the price of products or services. Inflation does not always have a negative economic impact. Inflation that is kept under control can help the economy recover, but inflation that is too high can hurt the economy. Some of the negative effects of inflation are listed below:
A Decrease in Purchasing Power
You may have heard your grandparents tell you about what they can purchase for a peso; a kilo of rice, a few fish, and some veggies can be enough to make a decent lunch. However, a peso now is not worth as much as it once was, and you could definitely buy candies with it. The purchasing power of a currency depreciates over time due to inflation.
The number of products and services that can be purchased with a unit of cash or monetary unit is referred to as purchasing power.
Assume the Philippines’ Central Bank chose to print more money and distribute hundreds of thousands of pesos to each person. Everyone will go to stores and buy things if they have this much money. As demand grows, businesses will raise the price of the commodity so that more people can buy it. What if the business decides not to raise the price? To match the demand, they will need to produce more products and hire more personnel. Will they accept a low pay because they all have hundreds of thousands of pesos? Most likely, the answer is no. Businesses will have to pay greater wages, which will eventually result in a price hike.
Undervalued Savings
If commodity prices rise, savings will be impacted as well. For example, suppose you’ve been putting money aside to buy a $200,000 home. You were able to raise this amount of money after 5 years, however the country is currently facing inflation. The house you wanted to buy has suddenly increased in value to $2,500,000. Your savings are no longer sufficient to purchase the home you desire, and you will need to increase your savings.
Inflation is a typical occurrence in all countries, and it can be advantageous to the economy in some instances. However, a country must keep this under control; otherwise, hyperinflation may result.
Hyperinflation
The rapid acceleration of inflation is known as hyperinflation. It immediately depreciates the currency’s value. It may happen in exceptional circumstances, but if it does, it will result in an economic downturn. As resources become limited, the boom in money manufacturing will be of no use.
The hyperinflation in Zimbabwe is one of the most well-known hyperinflation episodes in history. In November 2008, the predicted inflation rate was 79,600,000,000%, with prices doubling every single day. If a loaf of bread costs $35 million, a daily pay of $20 million is still insufficient.
Hyperinflation in the Philippines
During World War II, the Philippines experienced hyperinflation. The Japanese occupation of the Philippines resulted in the creation of fiat currencies for general circulation. Fiat money was dubbed “Mickey Mouse money” due to its lack of worth.
Survivors of the conflict frequently recount stories of bringing suitcases or bayong (local bags made of woven coconut or buri leaf strips) brimming with Japanese cash. A box of matches cost more than 100 Mickey Mouse pesos at the time. In 1942, the greatest denomination was ten pesos. However, after the end of the war, the Japanese government was obliged to create 100-, 500-, and 1000-peso notes due to inflation. In January 1944, it reached a high of 60 percent inflation. (Image credit: Wikipedia)
When is printing more money possible?
The Bangko Sentral ng Pilipinas (BSP) is the Philippines’ national monetary authority. It is charged with ensuring the country’s economic stability through overseeing banking operations and exercising regulatory control over non-bank financial entities. To avoid a downturn in events that could result in high inflation and rapid unemployment, it must carefully formulate policies and make judgments.
In general, the government issues money to replace old ones, balancing the economy’s money supply. However, in some circumstances, the BSP may contemplate printing more money to be circulated, such as the following:
Control Prices and Inflation
Inflation isn’t always a terrible thing; if it’s kept under control, it can help the economy flourish. BSP’s monetary policy fosters price stability since it has the exclusive authority to affect the amount of money circulating in the economy. Based on the assumption that there is a stable and predictable link between money, production, and inflation, the BSP can determine the amount of money required to achieve its desired inflation rate and sustain economic growth.
Recession
During a recession, when there is a large drop in economic activity, it may be necessary to create more money to avert deflation. Deflation has the potential to harm the economy by reducing consumer spending and slowing economic growth. Increasing the money supply would boost aggregate demand, helping to alleviate the recession.
Quantitative Easing
The Central Bank purchases financial assets from banks and other financial institutions as part of its quantitative easing (QE) policy. The purpose is to encourage banks to lend money to businesses and consumers at reduced interest rates, hence increasing expenditure and stimulating the economy. Although this technique expands the money supply, it does not include the printing of bills; instead, the Central Bank generates money electronically by boosting bank reserves. Given the risk of inflation, quantitative easing should be considered a last resort in a financial crisis.
The Bangko Sentral ng Pilipinas (BSP) recently adopted this method. The Monetary Board allowed the BSP to purchase securities from the Bureau of Treasury via a repurchase agreement during the COVID-19 pandemic. This will be used to fund government efforts aimed at combating the corona virus’s consequences.
It’s not as simple as it sounds to make extra money. More money printing can lead to damaging inflation, while a lack of money supply can lead to deflation, which can affect the economy. The Bangko Sentral ng Pilipinas is in charge of maintaining the balance.
We should not be reliant on the government to meet our basic needs. Individually, we can grow our wealth through our work, enterprises, and investments.