When the rate of inflation differs from expectations, the amount of interest repaid or earned differs from what they expected. Unexpected inflation hurts lenders since the money they are paid back has less purchasing power than the money they lent out.
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.
What happens if inflation occurs unexpectedly?
So, how does unforeseen inflation work in practice? Let’s look at an illustration.
The Shoe Company is a shoe store that caters to people of all ages. The corporation often reaps significant gains from unanticipated inflation. When inflation happens unexpectedly, the cost of things increases. This implies that The Shoe Company makes more money since they are paid more for their goods. Profits have risen, but wages have not kept pace with the higher prices customers must now pay for these things. When unanticipated inflation happens, The Shoe Company might expect to enjoy higher profits for a period of time until salaries begin to rise to keep up with the increase in products.
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.
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.
It’s time to put your skills to the test.
Remember to think about your replies before selecting one from the list.
Quizlet: What is the impact of unexpected inflation?
What are the consequences of unexpected inflation? Unprecedented inflation results in arbitrary income redistributions.
Does unforeseen inflation reduce the true burden of the federal government’s public debt?
Unexpected inflation reduces the real burden of the federal government’s public debt. Real income is calculated by deflating nominal income to account for inflation.
What are examples of the difficulties or inconveniences that inflation has caused?
Inflation has the following negative macroeconomic repercussions in addition to rising consumer costs, which disproportionately affect low-income households:
1. Interest rates that are higher.
In the long run, inflation leads to higher interest rates. When the government expands the money supply, interest rates fall at first because there is more money available. However, the increasing money supply causes higher equilibrium prices and a decreased value of money, causing banks and other financial institutions to hike rates to compensate for the loss of purchasing power of their funds. Higher long-term rates deter corporate borrowing, resulting in lower capital goods and technology investment.
2. A decrease in exports.
Higher goods costs suggest that other countries will find it less appealing to buy our products. This will result in a drop in exports, decreased output, and increased unemployment in our country.
3. Less money saved.
Inflation pushes people to spend instead of save. People are more likely to buy more things now, before they become more expensive later. They discourage people from saving since money saved for the future will be worth less. Savings are required to raise the amount of money available in the financial markets. This enables companies to borrow money to invest in capital equipment and technology. Long-term economic growth is fueled by advances in technology and capital goods. Inflation encourages people to spend more, which discourages saving and inhibits economic progress.
Malinvestments are number four.
Inflation leads to poor investing decisions. When prices rise, the value of some investments rises more quickly than the value of others. Prices of existing houses, land, gold, silver, other precious metals, and antiques, for example, rise when inflation rises. During periods of rising inflation, more money is invested in these assets than in other, more productive assets. These assets, on the other hand, are existing assets, and investing in them does not expand our nation’s wealth or employment. Rather than investing in businesses that generate new wealth, monies are diverted to assets that do not add to the country’s economic capability. Because of shifting inflation, investing in productive and innovative business operations is risky. An investor planning to spend $2 million in a new business anticipates a specific return. If, for example, inflation is 12%, the rate of return must be at least that, or the investor will lose real income. If the investor is concerned that he or she will not be able to return at least 12 percent on the investment, the new firm will not be started.
Furthermore, while present property owners may benefit from an increase in the value of their properties, current property buyers suffer. Current customers pay exaggerated prices for land, housing, and other goods. Some workers who may have bought a home ten or fifteen years ago are unable to do so now.
5. Government spending that is inefficient.
When the government uses newly issued money to support its expenditures, it simply collects the profits made by the Federal Reserve System on the newly printed money. Free money is not spent as wisely or efficiently as money earned via greater hardship, according to experience. There is a level of accountability when the government raises taxes to raise revenue. There is no accountability when the government obtains funding through newly minted money until citizens become aware of the true cause of inflation.
6. Increases in taxes.
Taxes rise in response to rising prices. Nominal (rather than actual) salaries rise in tandem with inflation, pushing higher-income individuals into higher tax rates. Despite the fact that purchasing power does not improve, a person pays the government a larger portion of his or her income. Houses, land, and other real estate are all subject to higher property taxes. Tax rates will remain constant if the government modifies the brackets in lockstep with inflation; unfortunately, the government sometimes fails to adjust the brackets, or just partially adjusts them. Higher tax rates will result as a result of this.
Why do governments (more precisely, central banks, or in the United States, the Federal Reserve) continue to print money and induce inflation, despite the risks? This can be explained in a number of ways. The ability to print money provides governments with unrestricted access to funds. Every year, the Federal Reserve prints billions of dollars and distributes them to the general government, which spends the money on various products. Furthermore, printing money can stimulate the economy in the near run because an increase in the money supply decreases short-term interest rates. Many individuals (especially politicians, because elections occur regularly) favor short-term rewards over long-term ones in our age of immediate gratification.
Another benefit of inflation (for the government) is that it raises nominal wages and pushes people into higher tax rates if tax brackets are not fully adjusted (see harmful effect 6 above). Increased taxes equal more income for the government (and people won’t blame politicians for higher taxes if they don’t understand why inflation is occurring).
Finally, borrowers who have borrowed money benefit from inflation because they may repay their loans in deflated dollars. Governments are the greatest borrowers in most economies, so they have a vested interest in keeping inflation high. People who save, on the other hand, have the opposite problem (mostly private citizens that save and people that try to build up a pension). Inflation reduces the value of future savings, putting many ordinary persons at a disadvantage. Financial markets are also damaged (see adverse effect 3 above), as less funds are accessible in the financial markets as savings decline (i.e. less money for research and development, business expansions, etc.).
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.
Who benefits the most from 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.