Who Gains and Who Loses from Inflation?
Inflation creates winners and losers. Knowing who wins is important for understanding why it is sometimes allowed to persist. When inflation is expected and stable, it is rather benign. People and institutions can plan for it and build it into their decision-making. If inflation is unexpected, it creates a win-lose situation in society. Who stands to gain from inflation?
Benefiting from Inflation
First consider what inflation is: a general increase in prices and a corresponding decrease in money's purchasing power. Borrowers benefit from a general increase in prices or a reduction in purchasing power. When individuals, businesses, and governments borrow, it is usually at a fixed rate of interest that had some expected level of inflation built into it. If higher than expected inflation occurs, then the real value of the borrower's debt is reduced. Assume that banks lend billions of dollars at a fixed nominal interest rate of 5%. If inflation were to unexpectedly increase from 2% to 4%, then borrowers' real interest rate paid would be reduced from 3% to 1%. In simpler terms, the money that was lent was more precious than the money being repaid.
Another group that benefits from an increase in consumer prices in the short run is producers. When unexpected inflation occurs, consumer prices rise while wages paid to employees remain relatively stable. This allows producers to experience higher profits for a time until wages adjust to reflect the higher prices consumers are paying.
In the past, many governments in the developing world tried erasing their foreign debts by overprinting their currency. Faced with much external debt, governments would devalue their currency in order to satisfy the debt. Given the current size of the United States debt, some fear that the American government might be tempted to do something similar. Most developed nations have independent central banks to act as a check on government's incentive to overprint currency. In the United States, the Federal Reserve is somewhat insulated from political pressure and can constrain the money supply when government's incentives are to expand it.
Losing with Inflation
Inflation harms more than helps. Lenders and savers both lose when inflation exceeds expectations. Both earn interest rates that assume some rate of inflation, and when the actual rate exceeds the expected rate, savers and lenders are harmed. Maybe you save money in a bank CD. Assume you purchase a $1,000 one-year simple CD that pays 4% nominal interest. If inflation increases unexpectedly from 2% to 5%, then the real interest rate you earn is approximately -1%. You are worse off than when you started. In nominal terms you still made $40.00 of interest. The problem is that the $1040 that you now have has less purchasing power than the $1000 you started with.
Inflation is thought to be harder on those with lower incomes. People with low incomes tend to have more of their wealth in the form of cash than do those with higher incomes. High-income earners have cash to be sure, but they also are more likely to have much of their wealth in other real and financial assets. For the poor, inflation exacts a heavier toll because it destroys the value of their chief asset, which is cash. The higher-income earners are able to offset some of inflation's effect by holding assets that actually appreciate with inflation.
Those living on fixed incomes are also harmed by inflation. During periods of unanticipated inflation, fixed-income earners see their real incomes decline. Professionals on a fixed salary or retirees living on a fixed pension lose purchasing power as long as the rate of inflation exceeds the rate at which their pay increases. To mitigate some of these effects, employers, or in the case of social security recipients, the government, will adjust pay to inflation through the use of cost of living adjustments (COLA). Even with COLA, fixed-income earners are still harmed by inflation as the cost adjustment lags inflation. During periods of higher than expected inflation, fixed-income earners are forever playing a game where their pay increases are too little and come too late.
Next time you sit down at a restaurant with laminated menus, consider what that says about inflation. When restaurants laminate their menus they are not only protecting them from spills, but they are also testifying that prices are relatively stable. When inflation is out of control, restaurants must continually update their prices, so they do not want to fix prices on the menu. Unlike most restaurant prices, seafood prices are highly volatile; that is why they are usually priced on a chalkboard.
Inflation creates practical problems for individuals and businesses in an economy. Because money is quickly losing value, consumers must engage in transactions more frequently as they rush to spend whatever money they have. The increase in transactions creates what is called shoe-leather costs. You wear out your shoes quicker when inflation is present because of the increase in your transactions. Inflation also poses a problem for producers who constantly have to reprice their goods as inflation continues. Remember that there is no such thing as a free lunch. Placing prices on goods is not free. If inflation is high, then significant costs are created as businesses pay employees to reprice their items. Persistent inflation results in forgone output as labor resources are put to the task of keeping up with ever-changing prices.