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.
Who is harmed by unexpected inflation?
Savers and creditors suffer from unanticipated inflation since the money they give out is repaid in cheaper currency over time. Borrowers and debtors benefit from unexpected inflation because they borrow money at a fixed rate and pay it back in cheaper dollars over time.
Who is the most affected by inflation?
Inflation is defined as a steady increase in the price level. Inflation means that money loses its purchasing power and can buy fewer products than before.
- Inflation will assist people with huge debts, making it simpler to repay their debts as prices rise.
Losers from inflation
Savers. Historically, savers have lost money due to inflation. When prices rise, money loses its worth, and savings lose their true value. People who had saved their entire lives, for example, could have the value of their savings wiped out during periods of hyperinflation since their savings became effectively useless at higher prices.
Inflation and Savings
This graph depicts a US Dollar’s purchasing power. The worth of a dollar decreases during periods of increased inflation, such as 1945-46 and the mid-1970s. Between 1940 and 1982, the value of one dollar plummeted by 85 percent, from 700 to 100.
- If a saver can earn an interest rate higher than the rate of inflation, they will be protected against inflation. If, for example, inflation is 5% and banks offer a 7% interest rate, those who save in a bank will nevertheless see a real increase in the value of their funds.
If we have both high inflation and low interest rates, savers are far more likely to lose money. In the aftermath of the 2008 credit crisis, for example, inflation soared to 5% (owing to cost-push reasons), while interest rates were slashed to 0.5 percent. As a result, savers lost money at this time.
Workers with fixed-wage contracts are another group that could be harmed by inflation. Assume that workers’ wages are frozen and that inflation is 5%. It means their salaries will buy 5% less at the end of the year than they did at the beginning.
CPI inflation was higher than nominal wage increases from 2008 to 2014, resulting in a real wage drop.
Despite the fact that inflation was modest (by UK historical norms), many workers saw their real pay decline.
- Workers in non-unionized jobs may be particularly harmed by inflation since they have less negotiating leverage to seek higher nominal salaries to keep up with growing inflation.
- Those who are close to poverty will be harmed the most during this era of negative real wages. Higher-income people will be able to absorb a drop in real wages. Even a small increase in pricing might make purchasing products and services more challenging. Food banks were used more frequently in the UK from 2009 to 2017.
- Inflation in the UK was over 20% in the 1970s, yet salaries climbed to keep up with growing inflation, thus workers continued to see real wage increases. In fact, in the 1970s, growing salaries were a source of inflation.
Inflationary pressures may prompt the government or central bank to raise interest rates. A higher borrowing rate will result as a result of this. As a result, homeowners with variable mortgage rates may notice considerable increases in their monthly payments.
The UK underwent an economic boom in the late 1980s, with high growth but close to 10% inflation; as a result of the overheating economy, the government hiked interest rates. This resulted in a sharp increase in mortgage rates, which was generally unanticipated. Many homeowners were unable to afford increasing mortgage payments and hence defaulted on their obligations.
Indirectly, rising inflation in the 1980s increased mortgage payments, causing many people to lose their homes.
- Higher inflation, on the other hand, does not always imply higher interest rates. There was cost-push inflation following the 2008 recession, but the Bank of England did not raise interest rates (they felt inflation would be temporary). As a result, mortgage holders witnessed lower variable rates and lower mortgage payments as a percentage of income.
Inflation that is both high and fluctuating generates anxiety for consumers, banks, and businesses. There is a reluctance to invest, which could result in poorer economic growth and fewer job opportunities. As a result, increased inflation is linked to a decline in economic prospects over time.
If UK inflation is higher than that of our competitors, UK goods would become less competitive, and exporters will see a drop in demand and find it difficult to sell their products.
Winners from inflation
Inflationary pressures might make it easier to repay outstanding debt. Businesses will be able to raise consumer prices and utilize the additional cash to pay off debts.
- However, if a bank borrowed money from a bank at a variable mortgage rate. If inflation rises and the bank raises interest rates, the cost of debt repayments will climb.
Inflation can make it easier for the government to pay off its debt in real terms (public debt as a percent of GDP)
This is especially true if inflation exceeds expectations. Because markets predicted low inflation in the 1960s, the government was able to sell government bonds at cheap interest rates. Inflation was higher than projected in the 1970s and higher than the yield on a government bond. As a result, bondholders experienced a decrease in the real value of their bonds, while the government saw a reduction in the real value of its debt.
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.
The nominal value of government debt increased between 1945 and 1991, although inflation and economic growth caused the national debt to shrink as a percentage of GDP.
Those with savings may notice a quick drop in the real worth of their savings during a period of hyperinflation. Those who own actual assets, on the other hand, are usually safe. Land, factories, and machines, for example, will keep their value.
During instances of hyperinflation, demand for assets such as gold and silver often increases. Because gold cannot be printed, it cannot be subjected to the same inflationary forces as paper money.
However, it is important to remember that purchasing gold during a period of inflation does not ensure an increase in real value. This is due to the fact that the price of gold is susceptible to speculative pressures. The price of gold, for example, peaked in 1980 and then plummeted.
Holding gold, on the other hand, is a method to secure genuine wealth in a way that money cannot.
Bank profit margins tend to expand during periods of negative real interest rates. Lending rates are greater than saving rates, with base rates near zero and very low savings rates.
Anecdotal evidence
Germany’s inflation rate reached astronomical levels between 1922 and 1924, making it a good illustration of high inflation.
Middle-class workers who had put a lifetime’s earnings into their pension fund discovered that it was useless in 1924. One middle-class clerk cashed his retirement fund and used money to buy a cup of coffee after working for 40 years.
Fear, uncertainty, and bewilderment arose as a result of the hyperinflation. People reacted by attempting to purchase anything physical such as buttons or cloth that might carry more worth than money.
However, not everyone was affected in the same way. Farmers fared handsomely as food prices continued to increase. Due to inflation, which reduced the real worth of debt, businesses that had borrowed huge sums realized that their debts had practically vanished. These companies could take over companies that had gone out of business due to inflationary costs.
Inflation this high can cause enormous resentment since it appears to be an unfair means to allocate wealth from savers to borrowers.
What happens if inflation occurs unexpectedly?
1. Income and wealth will be redistributed due to unanticipated inflation, or inflation that is not foreseen. The redistribution of wealth occurs when the prices of some assets rise faster than the price level, while the prices of others rise more slowly.
What impact does unexpected inflation have on borrowers?
Summary. Unexpected inflation hurts those whose money does not rise with inflation in terms of wages and interest payments. Inflation can favor those who owe money that can be repaid in less valuable, inflated currency. Inflation rates that are low have a limited economic impact in the short run.
Who benefits from inflation?
- Inflation is defined as an increase in the price of goods and services that results in a decrease in the buying power of money.
- Depending on the conditions, inflation might benefit both borrowers and lenders.
- Prices can be directly affected by the money supply; prices may rise as the money supply rises, assuming no change in economic activity.
- Borrowers gain from inflation because they may repay lenders with money that is worth less than it was when they borrowed it.
- When prices rise as a result of inflation, demand for borrowing rises, resulting in higher interest rates, which benefit lenders.
What are the effects of unexpected inflation on particular people and the economy as a whole?
Assume you borrow $1000 with a 5-year repayment period and a 5% yearly interest rate. You’ll have to pay back the loan when it’s due.
Assume, however, that the price level doubles during this five-year period.
Because a dollar will only be worth half as much in real terms, the amount of things you will have to give up to repay this loan will be half as much as the required dollar payment indicates.
As a result, you’ll only have to pay back $638.14 in real terms, based on the value of products at the time the money was borrowed.
This is fantastic from your perspective.
You’ll have borrowed $1000 in real goods for five years and only paid back $640 in actual things.
Substituting the real amount borrowed and the real amount repaid into the calculation will give you the interest rate you will have actually paid (rather than the 5% you negotiated for).
$1000 = $638.14 (1 + r)5, where r =- 1 = -.085 or minus 8.5 percent.
Despite the fact that you agreed to pay a 5% interest rate to the person you borrowed from, she ended up paying you 8.5 percent a year in interest to borrow from her.
Unprecedented inflation has shifted wealth from your creditor to you.
You’ve agreed to pay $1276.28 over five years, but you’ll only pay $638.14 in real terms.
To put it another way, the $1276.28 you repay will only buy half as many things as was anticipated when the loan was taken out.
The present value of the difference is $638.14 (1 + r)5 = $500, discounted at the market interest rate of 5%. This figure is not surprising given that a doubling of the price level wipes out half of the loan’s value in current dollars.
Of fact, if you lend $1,000 to someone for five years and the price level unexpectedly doubles over the length of the loan, the person you lend to will earn $500 in current dollars at your expense.
Unexpected inflation redistributes wealth from those who have agreed to receive fixed nominal amounts in the future to those who have agreed to pay those fixed nominal amounts in the future.
Deflation that occurs unexpectedly has the opposite impact.
The individual who has borrowed a set nominal amount must repay with dollars that are worth more in terms of real goods than he or she contracted for, and the creditor is paid an amount that is bigger in real terms than expected, redistributing wealth from debtors to creditors.
The real interest rate actually realized on loans will differ from the interest rate at which the loan contract was established if there is an unanticipated movement in the price level.
In the case of one-year loans, this realized real interest rate is simple to calculate.
Assume you borrow $100 for a year at an agreed-upon interest rate of 6%, and the inflation rate turns out to be 3% rather than zero percent, as both you and the lender expected when you took out the loan.
At the end of the year, you pay the lender $106, but that $106 is only worth roughly $103 because $100 will only buy $3 less products at the end of the year.
As a result, the actual interest rate is only roughly $3/$100, or 3%.
The realized real interest rate is roughly equal to the contracted interest rate less the actual inflation rate.
In an economy, unanticipated inflation has significant wealth redistribution implications.
People who take out mortgages to buy properties at fixed interest rates end up paying more in real terms than they bargained for-wealth is redistributed from banks and other financial institutions (or, more accurately, the people who own them) to mortgage-holders.
Individuals who retire on fixed-dollar-amount pensions will see their pensions eroded in terms of the goods they buy as time passes-in this case, the redistribution is from pensioners to the owners of insurance companies and other financial institutions who have contracted to pay them fixed-dollar-amount pensions.
Inflation that is unexpected has additional distributional implications that are mediated by the tax system.
Many nations have progressive income tax systems, in which high-income individuals pay a larger percentage rate of tax on income increases than low-income individuals.
Because income tax rates are based on nominal rather than real income, rising nominal incomes will push people into higher tax brackets, increasing the amount of taxes paid to the government in a greater proportion than rising prices.
As a result, real tax payments and the government’s resource availability will rise.
Fully expected inflation has the same impacts unless the tax structure is changed to account for it.
Furthermore, in order to calculate the profits on which they must pay taxes to the government, business firms are typically allowed to subtract allowances for depreciation of their capital from their revenues.
Depreciation allowances are typically expressed as a percentage of the original cost.
These depreciation allowances based on the prices prevalent when the capital was purchased do not rise when inflation occurs and all nominal prices and salaries rise at the same time.
As a result, the real value of a firm’s cost deductions decreases, resulting in a rise in real taxes paid.
Because inflation does not cut the real costs of replacing depreciated capital and real taxes rise, a firm’s real profits fall.
Depending on the specific regulations that the tax legislation requires them to follow in computing their depreciation allowances, different industries will be affected differently.
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What impact does unexpected inflation have on savers?
Because prices are expected to rise in the future, inflation might erode the value of your investments over time. This is particularly obvious when dealing with money. If you keep $10,000 beneath your mattress, it may not be enough to buy as much in 20 years. While you haven’t actually lost money, inflation has eroded your purchasing power, resulting in a lower net worth.
You can earn interest by keeping your money in the bank, which helps to offset the effects of inflation. Banks often pay higher interest rates when inflation is strong. However, your savings may not grow quickly enough to compensate for the inflation loss.
Quizlet: What is the impact of unexpected inflation?
What are the consequences of unexpected inflation? Unprecedented inflation results in arbitrary income redistributions.