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## Macroeconomics

### Unit 2: Lesson 5

Costs of Inflation

# Lesson summary: The costs of inflation

AP.MACRO:
MEA‑1 (EU)
,
MEA‑1.H (LO)
,
MEA‑1.H.1 (EK)
In this lesson summary review and remind yourself of the key terms and calculations used in describing the costs of inflation.

## Lesson overview

Inflation can get a bad rap. For instance, some people think inflation makes everyone worse off. But it turns out that there are both winners and losers from inflation. In general, if you owe money that has to be paid back with a fixed amount of interest, you are going to benefit from unexpected inflation. On the other hand, if someone owes you money, when there is unexpected inflation the money you are paid back won’t be worth as much as the money you loaned out.

## Key Terms

TermDefinition
unanticipated inflationwhen the price level increases at a faster pace than expected; for example, if you think that the rate of inflation will be 5%, but it turns out to be 8%.
unanticipated disinflationwhen the price level increases at a slower pace than anticipated; for example, if you think the rate of inflation will be 5%, but it turns out to be 2%.
unanticipated deflationwhen the price level decreases when it was expected to increase; for example, if you think the rate of inflation will be 2%, but it turns out to be -2%.
wealth redistributionwhen the real value of wealth is transferred from one agent to another; when inflation is higher than borrowers and lenders expected, wealth is transferred from lenders to borrowers.
lenderan agent (usually a bank) or a person (for example, a holder of a bond) who makes money available to another agent, with the agreement that the money will be repaid (usually with interest)
borroweran agent that has received money from another agent with the agreement that the money will be repaid (usually with interest)
saveran agent that is not spending some of their income; usually if money is saved it is put in some sort of interest-earning asset (like a savings account or a bond) or purchasing some other financial asset (such as stocks and bonds).
bondan asset that is a promise to pay a fixed amount at some point in the future; for example, the government sells Tony a bond for dollar sign, 100 with the promise of paying him back dollar sign, 104 in one year, which allows Tony’s savings to earn interest.

## Key takeaways

### The redistribution effect of inflation

Unexpected inflation arbitrarily redistributes wealth from one group to another group, such as from borrowers to lenders. When people decide to borrow money or lend money, they often consider what they think the rate of inflation will be. When the rate of inflation is different than anticipated, the amount of interest repaid or earned will also be different than what they expected.
• Lenders are hurt by unanticipated inflation because the money they get paid back has less purchasing power than the money they loaned out.
• Borrowers benefit from unanticipated inflation because the money they pay back is worth less than the money they borrowed.

### The redistribution effects of disinflation and deflation

Unanticipated disinflation or deflation, when the inflation rate is lower than it was expected to be (or even negative), has the opposite effect as unanticipated inflation: lenders are helped and borrowers are hurt.
Lenders are helped by unanticipated disinflation or deflation because the money they get paid back has more purchasing power than the money they expected it to be when they loaned it out.
Borrowers are hurt by deflation in particular because they have to pay back their debts with money worth more than the money they borrowed in the first place!
Most policies that target inflation are aimed at maintaining small and predictable rates of inflation. Inflation that is too close to zero runs the risk of becoming negative, and deflation becomes a possibility. Deflation has a very damaging impact on an economy and is associated with particularly severe recessions and depressions. If you hear about policymakers talking about "lowering inflation," their objective is slowing down the rate of inflation (in other words, disinflation), not deflation.

## Common misperceptions

• A common misperception is that inflation is bad for everyone (who likes more expensive stuff?). But this is not the case. Inflation reduces the value of money. Because of that, people who have borrowed money benefit from a higher inflation rate when they pay the money back. The interest rate that a borrower pays is effectively lower thanks to inflation.
• Another common misperception is that disinflation and deflation are good for everyone (who doesn't enjoy cheaper stuff?). The problem is, deflation increases the purchasing power of money. People who have borrowed money are paying back that loan with money that is effectively worth more than the money they borrowed. Deflation effectively increases the interest rate that a borrower pays.
• A very common misperception is that inflation should always be avoided. Deflation has such a destructive impact on an economy that most policymakers agree that avoiding deflation is a far more important objective. As a result, the goal of policymakers is not zero inflation, but small and predictable inflation rates.

## Discussion questions

1) Suppose you take out a dollar sign, 50, comma, 000 loan from the Bank of Baloney to pay for college, and they give you five years to pay back the loan. If inflation unexpectedly increases over the next five years, who is helped by the inflation, you or the bank?
2) The Lady of Wintersfell has borrowed dollar sign, 2, point, 5 million dollars from the Iron Bank of Bravodos which she promises to pay back in five years. During those five years there is unanticipated deflation across the kingdom. How does this deflation redistribute wealth between the borrowers and lenders? Explain.
3) You inherit a fortune of dollar sign, 100, which you place in a secure savings account that has a fixed interest rate. The inflation rate ends up being higher than you anticipated when you first placed your money in the bank. Does your expected wealth increase, decrease, or stay the same over time? Explain.

## Want to join the conversation?

• What about producers of products. You produce apples. You sell them. Inflation went up so what does that mean for the producer - will he make more money because apples cost more than the year before?
• If by "make more" you mean profit, well, that depends. In the short run, an apple producer might benefit from inflation because some of their costs don't change. For example, suppose you hire workers at $10 per hour on a one-year contract. Midway through the year there is inflation so the price of apples increases. IN that case, yes, you might benefit from inflation. In fact, you would even respond to that inflation by producing more. But, in the long run, those workers will eventually want higher wages because of inflation. Once all of those costs have also adjusted, the producer doesn't benefit at all any more. This is actually covered in a later lesson on something called "Short-run aggregate supply". (12 votes) • I still did not quite fully understand why 0 inflation, i.e., no change, is a bad thing. Shouldn't this be the ideal goal? (4 votes) • At exactly zero inflation, there is a risk that inflation may turn negative(deflation). In the case of high inflation, interest rates may be raised, as much as required, but in the case of deflation monetary policy is limited as interest rates can at most be reduced to only 0 in most cases. Deflation can result in monetary policy becoming ineffective so having a little inflation lowers the risk of entering a deflationary situation. (6 votes) • Game of Thrones question number 2? :D (5 votes) • what is the effect of a rise in unexpected inflation by 5% on the following people; 1 a union member with a wage contract 2.someone with a large stash of cash in safe deposit 3.a bank lending money at a fixed interest rate 4.a person who is not due to receive a pay raise for another 11 months (4 votes) • What's the difference in fixed rates and variable rate and who does it help or hurt? (3 votes) • It is repeatedly stated that 'deflation has devastating effects'. What exactly are the devastating effects? Can someone explain with example? If prices are lesser, people will simply have to borrow lesser, won't that be a good thing? (2 votes) • Well prices drop because firms are forced to sell for whatever reason, if they need to liquidate it is likely production will slow as well. possibly even lay off many resulting in high unemployment (2 votes) • "Unexpected inflation arbitrarily redistributes wealth from one group to another group, such as from borrowers to lenders." This confuses me, as from what I understand, inflation is bad for lenders and good for borrowers... Is this a mistake or a mistype, or have I misunderstood? Thanks! (2 votes) • Hi I need some help understanding why this answer is correct. QUESTION: "Ygritte loaned Mance$900 He agreed to repay her in full, plus 6%percent interest, after one year. When he pays off his loan, Mance discovers he is better off than he had expected to be. Which of the following best describes what must have happened to the rate of inflation?