What this lesson teaches
I can explain how inflation affects savers, lenders, borrowers, consumers, workers, firms and the economy.
Syllabus K343, 4.7.4. Consequences of inflation: how inflation affects savers, lenders and borrowers; consequences of inflation for consumers, workers, producers/firms and the economy
Make a guess
Prices rise 10% unexpectedly. You owe a friend a fixed $500. Who gains in real terms?
- Your friend, because $500 is still $500.
- Neither, because the debt is fixed.
- You, the borrower.
Show the answer
You, the borrower.
The $500 you repay buys less than when you borrowed it, so in real terms you repay less. Your friend, the lender, loses.
Inflation hurts savers, lenders and people on fixed incomes, can help borrowers, and makes a country's exports less competitive.
Savers lose if the interest rate on their savings is lower than inflation. Their money buys less when they spend it. Lenders lose for the same reason: the money repaid is worth less than the money lent.
Borrowers can gain, because they repay debts with money that is worth less. A fixed loan repayment becomes easier to pay as wages rise with inflation.
Consumers lose if their incomes rise more slowly than prices, so their real income falls. Workers on fixed wages, and retirees on fixed pensions, are hit hardest. Workers in strong bargaining positions may win pay rises to keep up.
Firms face uncertainty, so they may delay investment. They must spend time and money changing prices. If inflation is higher than in other countries, exports become less competitive and imports more attractive. Low, stable inflation does little harm, but high or unpredictable inflation is damaging.
- Savers and lenders
- Lose if inflation exceeds the interest rate.
- Borrowers
- May gain: debts are repaid with money worth less.
- Fixed incomes
- Real income falls.
- Economy
- Uncertainty, menu costs, less competitive exports.
Worked example: Real value of savings
Suppose you save $1,000 at 1% interest while inflation is 4%.
- After a year you have $1,010.
- But goods that cost $1,000 now cost $1,040.
- Your savings buy about 3% less than before: you have lost real value.
- A borrower who owes a fixed $1,000 gains in the same way: the debt is worth less in real terms.
Watch out for this
Inflation harms everyone equally.
Inflation shifts wealth between groups. Savers, lenders and people on fixed incomes lose; borrowers may gain; workers whose pay keeps up are less affected.
Check your understanding
Prices rise faster than anyone expected. Who is most likely to gain?
- A saver with cash at low interest.
- A borrower repaying a fixed sum.
- A retiree on a fixed pension.
Show the answer
A borrower repaying a fixed sum.
Right. The fixed repayment is worth less in real terms, so the borrower repays less in goods.
Check your understanding
Inflation is 4% a year and a savings account pays 1% interest a year. What happens to the saver?
- Her savings buy more goods each year
- The real value of her savings stays the same
- She gains, because her balance keeps rising
- The real value of her savings falls
Show the answer
The real value of her savings falls
Right. Prices rise faster than her savings grow, so they buy less each year.