In this lesson, you'll discover who benefits and who suffers from a sustained increase in prices within an economy. We'll cover the effects of expected and unexpected inflation on savers/creditors and borrowers/debtors.
Effects of Inflation on Suppliers and Demanders
I want you to imagine for a minute several people in your neighborhood, each of whom is invited to a neighborhood block party. This neighborhood block party is going to happen in a few hours. So here's a description of your neighbors:
- Alyson is a retired woman living on Social Security payments.
- Lydia is a neighbor who works on an assembly line in a car factory.
- Frank is a farmer who just bought a tractor for his farm, which is next to his house.
- Davis is a neighbor who just closed a 30-year, fixed-rate mortgage on his new home.
Let's say that last year the inflation rate was 3%. People are expecting this year to be 3% also. However, an hour ago, each of these neighbors discovers, while watching the national news on television, that inflation is actually 5% - it's not 3% like everyone expected, it's 5%. As you watch the same news report on television, you begin to ask yourself the question: which one of your neighbors is going to be happy at the party?
Let's look at this from an economic perspective. What we want to know is: What are the effects of inflation on suppliers and demanders? Another way to say this is: Who gets hurt and who gets helped by unanticipated, or unexpected, inflation? Anticipated inflation is a sustained rise in the price level that is expected ahead of time. Inflation that is anticipated, or expected, isn't as bad as unanticipated inflation, which is a higher-than-expected sustained increase in the price level. When inflation is expected, it gets included in the price of goods and services today, as well as the interest rates on loans and various investments. Anticipated inflation benefits anyone whose income is tied to inflation. An example of this would be workers with ongoing cost-of-living adjustments that are tied to inflation.
The effects of inflation on lenders and borrowers depends on whether it is anticipated or not.
Let's spend the majority of our time in this lesson talking about unanticipated inflation. Unanticipated inflation hurts savers and creditors because the money they lend out gets paid back in cheaper dollars over time. On the other hand, unanticipated inflation helps borrowers and debtors because they borrow money at a fixed rate and pay it back in cheaper dollars over time. Here's another way to say this: unanticipated inflation redistributes wealth from savers to borrowers. When you're trying to determine who is hurt or helped by surprise inflation, you have to first determine if they are considered a saver or creditor (meaning that they loan out money) or are they are a borrower or debtor (meaning that they are borrowing money).
Let's look at inflation's effects from all the guests invited to the neighborhood block party. Remember, Alyson is a retired woman living entirely on Social Security income, so that's how she gets her money every month. The check comes in the mail from Social Security, she puts it in her bank account and that's what she lives on. Is she hurt or helped when she finds out that inflation is actually 5% when we were expecting 3%? Social Security is like a savings account in that it pays fixed income payments over time to individuals. That means she would be considered a saver, and we know that savers are hurt by unanticipated inflation. When she receives the same fixed payment over time, it will actually be worth less and less in terms of the goods and services it will afford her. Unfortunately, Alyson is going to be quite sad at the party!
Frank (is a farmer I said) borrowed money to buy a new tractor. Therefore, is Frank going to be hurt or helped? We know that borrowers are helped by unanticipated inflation, so this farmer benefits because his monthly payments on the tractor he borrowed the money to buy will actually be worth less and less. He'll be paying back his loan in cheaper dollars. So that means that at the party, Frank's going to be very happy.
Lydia, a worker on an assembly line in a car factory, receives a fixed cost-of-living adjustment of 3% per year. She has a contract, and it's going to automatically go up by 3% every year. The reason why it was 3% is because that's what the expected inflation was. But remember, we found out that the actual inflation rate is higher; it was 5%. So, is Lydia hurt, or is she helped? Well, if a worker's contract includes a fixed increase of 3% per year, but actual inflation turned out to be 5%, then workers would be hurt because their incomes are rising at 3% but prices are rising by 5%. This situation would be the opposite if inflation turned out to be less than expected - let's say inflation turned out to be 1% instead of 3%, then it would be the opposite. In this case, it was 5% instead of 3%, so that means Lydia is going to be very sad at the party.
Davis is also coming to the party. Davis obtained a mortgage to purchase a new home. Is Davis hurt or helped? Since a mortgage is a loan that means Davis is a borrower, and borrowers are helped by unanticipated inflation. If he borrows $100,000 at a fixed rate of, say, 6%, the monthly payments for a 30-year mortgage are going to be the same throughout the loan. However, unanticipated inflation is going to reduce the purchasing power of those payments, so that Davis will be paying back the loan in cheaper dollars. That means Davis is going to be quite happy at the party!
Alright, let's think about this one: the Federal Government. Is the Federal Government hurt or helped by unanticipated, or unexpected, inflation? The Federal Government is a major winner from unexpected inflation because the government borrows money to fund its operations. Because it borrows at fixed rates of interest, the interest payment it pays to government bond holders is going to be worth less and less over time, since prices for goods and services have risen above what was expected.
Let's summarize what we've talked about. Anticipated inflation is a sustained increase in the price level that is expected ahead of time. Unanticipated inflation is a higher-than-expected sustained increase in the price level; in other words, prices are going up faster than what was expected. Unanticipated inflation hurts savers and creditors because the money that they lend out gets paid back in cheaper dollars over time. Unanticipated inflation helps borrowers and debtors because they borrow money at a fixed rate and pay it back in cheaper dollars over time. Finally, unanticipated inflation redistributes wealth from savers to borrowers.
Once you complete this lesson you'll have a thorough understanding of how anticipated and unanticipated inflation affects suppliers and demanders.