The Price Level and Inflation: How Inflation Can Redistribute Income

How Inflation Can Redistribute Income Inflation is great for people who are in debt, because the purchasing power of dollars will decline over the life of their loans. Borrowers will therefore pay back principal and interest in dollars that are worth less each year in terms of purchasing power. Inflation tends to decrease the burden of paying off loans because debtors make payments in dollars that have less purchasing power than those they borrowed! Inflation will decrease the wealth of creditors, who will experience a reduction in the purchasing power of the outstanding balances on loans they carry on their books as assets. For example, suppose you borrowed mortgage money in 1967. Assume the outstanding balance on your loan in 1987 was $10,000. Because the purchasing power of a dollar in 1987 was only about one third of its purchasing power in 1967, the outstanding balance valued in 1967 dollars (when the money was spent to buy the house) was only $3,333. In this way inflation redistributes wealth (asset values) from creditors to debtors. In effect, savers can be regarded as creditors. Those who have savings accounts in banks, such as 10-year certificates of deposit, are harmed by inflation because the purchasing power of their savings will be eroded unless the interest they earn is high enough to compensate them for the effects of inflation. For example, suppose you purchase a 5-year certificate of deposit that yields 10-percent interest per year. If inflation is 20 percent per year, you'll lose purchasing power on your savings each year. Although the balance will go up by 10 percent per year because of interest payments, the inflation of 20 percent will outstrip the interest payment. The net effect will be that the purchasing power of your savings will fall. Nominal Interest Rates versus Real Interest Rates The preceding analysis of the impact of inflation on debtors and creditors assumes that the interest rate doesn't adjust for the effects of inflation. You should recall the analysis of the impact of inflation on wages. Inflation is considered in the bargains that are struck between workers and employers. By the same token, inflation is considered in the bargains that are struck between borrowers and lenders. When lenders see inflation coming, they are less willing to make loans, because they know that future inflation will reduce the purchasing power of the dollars that will be repaid. As lenders anticipate the adverse effects of inflation on the profitability of lending, they decrease the supply of loanable funds and thus put upward pressure on interest rates. The nominal interest rate is the annual percentage amount of money that is earned on a sum loaned or deposited in a bank. The nominal interest rate is the contract interest on the face of the loan or deposit and will always be positive. For example, if you buy a $5,000 certificate of deposit that yields 10-percent annual interest, you are a creditor who loans the bank that sum for a period of time at a 10-percent nominal annual rate of interest. The real interest rate' is the actual annual percentage change in the purchasing power of interest income earned on a sum of money that is loaned out. When inflation is present, the real rate of interest will be less than the nominal rate. The real rate of interest is the nominal rate adjusted for the decrease in purchasing power that results from inflation. The earned real rate of interest can be thought of as the nominal interest rate minus the rate of inflation? For example, suppose the nominal interest rate you earned over a one-year period on a $5,000 certificate of deposit was 9 percent. If over the same period inflation averaged 6 percent, then the real interest rate you earned was 3 percent. The $5,000 principal plus the interest it earned over the period the bank held it, after adjustment for inflation, was worth only 3 percent more than it was when you deposited it. Although nominal interest rates are always positive, real interest rates can be negative when the actual rate of inflation exceeds the nominal interest rate. Lenders will incur losses on loans during periods when the nominal interest rate on the loan is less than the rate of inflation. Of course, given the nominal interest rate, lenders need not incur losses in future years on loans made when real interest rates are negative. Changes in the inflation rate over the life of the loan will affect the real interest rate earned in future years. Despite the fact that nominal interest rates soared to double digits in the late 1970s, borrowing was a good deal because roaring inflation at that time actually resulted in negative real interest rates! For example, in 1978 the real interest rate on three-month Treasury bills, which represent short-term borrowing by the federal government, was estimated to be - 1.5 percent. In periods like this, when nominal interest rates increase less rapidly than prices, borrowers benefit greatly while lenders are harmed. The graph in Box 6 shows how estimates ex ante (or anticipated) U.S. real interest rates anticipated by borrowers and lenders making loans have varied from 1919 to 1986. The measure of inflation used to estimate the real interest rate is the average percentage change in the CPI over the preceding two years. This measure is used as a very rough estimate of inflation anticipated by borrowers and lenders. It's assumed that, in making loans, market participants use past inflation as an indicator of future inflation. Subtracting this measure from the nominal interest rate for a composite of U.S. government bonds provides a rough measure of anticipated real interest rates. The anticipated real interest rate is the actual rate borrowers expect to pay when they obtain credit. As you can see, U.S. real interest rates were negative during the 1940s and early 1950s, and again during the late 1970s. When real interest rates are negative, it's a good time to borrow and a bad time to lend! As you can also see from the chart, estimated real interest rates soared in the early 1980s. Despite the fact that nominal interest rates fell after 1982, real interest rates moved up to near historic highs of almost 10 percent in 1983. This is why borrowing was more burdensome in 1983 than it was in the late 1970s, despite the decline in nominal interest rates over that period! The impact of inflation on borrowers and lenders is a bit more complex than discussed earlier. In that discussion interest rates were not assumed to adjust for inflation. It's really quite difficult to predict who gains and who loses, because market forces tend to adjust nominal interest rates as creditors seek compensation for the effects of inflation. If all long-term contracts involving loanable funds had clauses allowing automatic adjustment for inflation, there would be no redistribution of income from creditors to debtors arising from changes in the inflation rate.