Short on time? This page is the recap. For explanations and worked examples, use the full study guide.
Recap
- Expected inflation can be written into contracts (higher nominal interest rates, wage rises, indexed pensions).
- Unexpected inflation = actual inflation − expected inflation. Contracts already signed cannot adjust.
- Loans, wages and pensions are usually fixed in money. When prices rise more than expected, each fixed valda buys less.
- So unexpected inflation arbitrarily redistributes purchasing power: from lenders to borrowers, and from people receiving fixed nominal payments to those paying them.
- Unexpected deflation reverses this and raises the real burden of debt.
- Costs to the economy: unfair, luck-based redistribution; uncertainty that discourages long-term fixed-rate lending and investment; resources spent protecting against inflation.
Who gains and who loses
| Group | Unexpected inflation | Unexpected deflation |
|---|---|---|
| Lender with a fixed-rate loan | loses | gains |
| Borrower with a fixed-rate loan | gains | loses |
| Pensioner with a fixed, non-indexed pension | loses | gains |
| Saver holding cash | loses | gains |
| Worker on a fixed wage contract | loses | gains (if the job is kept) |
| Employer paying fixed wages | gains | loses |
Key relationship
| Relationship | Formula | Use it to |
|---|---|---|
| Purchasing power of a later payment | payment × (CPI at start ÷ CPI at end) | express it in start-of-period money |
| Indexed payment | payment × (CPI at end ÷ CPI at start) | keep purchasing power constant |
| Approximate real return | nominal interest rate − inflation rate | quick check (formalised in Topic 4.2) |
Mistakes to avoid
- Saying all inflation hurts lenders: only the unexpected part does.
- Saying borrowers lose from unexpected inflation.
- Saying deflation helps borrowers.
- Saying inflation makes everyone poorer: it redistributes.
- Flipping the CPI ratio when finding purchasing power.
Quick self-check
- A loan repayment of VD 1,050 is made when the CPI has risen from 100 to 105. What is it worth in start-of-year valdas? (VD 1,000: the lender earned nothing in real terms)
- Prices fall unexpectedly. Does a lender with a fixed-rate loan gain or lose? (Gain)
- A fixed pension of VD 600 a month after prices rise by 20%: purchasing power in old valdas? (VD 500)
Next: practice questions.