Expected and unexpected inflation
In Topic 2.4 you measured inflation with a price index. This topic asks a different question: who is hurt, and who is helped, when prices rise?
The key is whether the inflation was expected.
- Expected (anticipated) inflation is the inflation people predicted when they made their plans. If a lender expects prices to rise by 4%, she can ask for a higher interest rate to cover it. A union that expects 4% inflation can bargain for wage rises of at least 4%.
- Unexpected (unanticipated) inflation is the difference between the actual inflation rate and the rate people expected. Nobody could build it into the deals they had already signed.
Many agreements fix an amount of money, not an amount of goods. A loan contract says “repay VD 10,500”, not “repay enough to buy 700 loaves”. A pension promises “VD 1,200 a month”. When prices rise faster than expected, each of those fixed valdas buys less than the people who signed the deal planned. One side loses purchasing power and the other side gains it.
Unexpected inflation arbitrarily redistributes purchasing power (wealth) from one group to another. “Arbitrarily” means the gains and losses depend on luck and on which side of a contract you are on, not on how hard anyone worked.
Lenders and borrowers
A lender gives up spending power today in return for more spending power later. The interest rate written in a loan contract is a nominal rate: it is measured in money, not adjusted for inflation.
- If inflation is higher than expected, the borrower repays in valdas that buy less than expected. The borrower gains and the lender loses.
- If inflation is lower than expected, or prices actually fall (deflation), the borrower repays in valdas that buy more than expected. The lender gains and the borrower loses.
Worked example 1: a loan in Valdoria
Valdoria is the fictional country used across the Marlbridge macroeconomics pages; its currency is the valda (VD). All figures are fictional.
Question. Mira lends her cousin Tomas VD 10,000 for one year at a nominal interest rate of 5%. When they agree the loan, the CPI is 150 and both expect it to be 153 a year later (2% inflation). Find the purchasing power of the repayment, in start-of-year valdas, if the CPI at the end of the year turns out to be (a) 153, (b) 162, (c) 147. Who gains in each case?
Step 1: the repayment. VD 10,000 × 1.05 = VD 10,500. This amount is fixed whatever happens to prices.
Step 2: inflation in each case. (a) (153 − 150) ÷ 150 × 100 = 2%. (b) (162 − 150) ÷ 150 × 100 = 8%. (c) (147 − 150) ÷ 150 × 100 = −2% (deflation).
Step 3: purchasing power of the repayment = 10,500 × (150 ÷ end-of-year CPI), the method from Topic 2.4.
| Case | End CPI | Inflation | Repayment in start-of-year valdas | Change in Mira’s purchasing power |
|---|---|---|---|---|
| (a) as expected | 153 | 2% | 10,500 × 150 ÷ 153 = VD 10,294.12 | +2.94% |
| (b) unexpected inflation | 162 | 8% | 10,500 × 150 ÷ 162 = VD 9,722.22 | −2.78% |
| (c) unexpected deflation | 147 | −2% | 10,500 × 150 ÷ 147 = VD 10,714.29 | +7.14% |
The last column is (repayment in start-of-year valdas − 10,000) ÷ 10,000 × 100.
Interpretation.
- (a) Everything goes to plan. Mira gives up VD 10,000 of spending and gets back about 3% more in purchasing power. Nobody gains at the other’s expense.
- (b) Mira gets back less purchasing power than she lent. Tomas repays with valdas that are worth less than either of them expected, so Tomas (the borrower) gains and Mira (the lender) loses.
- (c) Prices fall, so each valda Tomas repays buys more. Mira gains and Tomas loses. His debt is harder to repay than he planned.
Check. A quick approximation is “nominal rate − inflation rate”: 5% − 2% = 3%, 5% − 8% = −3%, 5% − (−2%) = 7%. These are close to the exact figures. In Topic 4.2 you will call this the real interest rate.
What if the inflation had been expected?
Suppose Mira and Tomas had both correctly expected 8% inflation. Mira would ask for about 3% plus 8%, so 11%. Tomas would repay VD 11,100, worth 11,100 × 150 ÷ 162 = VD 10,277.78 in start-of-year valdas: about 2.78% more than she lent. Neither side is surprised, so neither gains at the other’s expense.
This is why economists focus on unexpected inflation. Fully expected inflation still has some costs (see the background box below), but it does not shift wealth between the two sides of a contract.
Other winners and losers
The same logic applies to any payment fixed in money terms.
| Group | Effect of unexpected inflation | Why |
|---|---|---|
| Lenders and banks with fixed-rate loans | lose | repaid in valdas that buy less |
| Borrowers with fixed-rate loans (for example, a fixed-rate home loan) | gain | repay in valdas that buy less |
| People on fixed nominal incomes (pensions not adjusted for prices) | lose | the same income buys less |
| Savers holding cash or earning a fixed low interest rate | lose | their savings buy less |
| Workers on multi-year fixed wage contracts | lose | the wage was set before prices rose |
| Employers paying those fixed wages | gain | they pay less in real terms while their own prices rise |
With unexpected deflation, every gain and loss in the table reverses: borrowers lose, lenders gain, and fixed incomes buy more. But a firm or household with debt now finds the debt harder to repay, because its income tends to fall with prices while the debt stays the same.
Worked example 2: a pension and some savings
Question. Arun retired in Valdoria with a fixed pension of VD 1,200 a month. He also has VD 5,000 in a savings account paying 2% a year. Over the year the CPI rises unexpectedly from 125 to 137.5. (a) Calculate the inflation rate. (b) Calculate the purchasing power of his pension at the end of the year, in start-of-year valdas. (c) Calculate the purchasing power of his savings after one year. (d) What pension would keep his purchasing power unchanged?
(a) (137.5 − 125) ÷ 125 × 100 = 10%.
(b) 1,200 × 125 ÷ 137.5 = VD 1,090.91. His pension buys (1,090.91 − 1,200) ÷ 1,200 × 100 = 9.09% less than before.
(c) After interest he has 5,000 × 1.02 = VD 5,100. Its purchasing power is 5,100 × 125 ÷ 137.5 = VD 4,636.36, which is 7.27% less than the VD 5,000 he started with. Interest of 2% does not make up for 10% inflation.
(d) 1,200 × 137.5 ÷ 125 = VD 1,320 a month. A pension that rises automatically with a price index is indexed (it has a cost-of-living adjustment). Indexing protects people from unexpected inflation.
Check. If prices had instead fallen unexpectedly, say from 125 to 120 (deflation of 4%), the same pension would be worth 1,200 × 125 ÷ 120 = VD 1,250 in start-of-year valdas: Arun would gain 4.17%.
Costs to the economy as a whole
Unexpected inflation does not destroy the purchasing power it moves; one group’s loss is another’s gain. So why is it a cost for the whole economy?
- Arbitrary redistribution. Wealth moves for reasons unrelated to effort, saving or productivity. Careful savers and pensioners lose; borrowers are rewarded by luck. This is widely seen as unfair, and it can hit people who are least able to protect themselves.
- Uncertainty and less lending. If lenders fear that inflation may surprise them, they become unwilling to make long-term loans at fixed rates, or they demand higher interest rates to cover the risk. Borrowing for houses, machines and factories becomes harder and more expensive, which can reduce investment.
- Resources spent on protection. Households and firms spend time and money writing indexed contracts, renegotiating wages and moving savings into assets that keep their value. Those resources could have produced something useful.
- Unexpected deflation raises the real burden of debt. Borrowers whose incomes fall with prices find fixed debts harder to repay. They may cut spending or default, which can harm lenders and the wider economy.
Background (not required for this topic). Even fully expected inflation has some costs. Menu costs are the costs of changing prices (reprinting price lists, updating systems). Shoe-leather costs are the time and effort people spend keeping less cash on hand when its value is falling. You may meet these in textbooks; the course objective for this topic concentrates on unexpected inflation and deflation.
Common misconceptions
- “Inflation always hurts lenders.” Only unexpected inflation does. Expected inflation is built into the nominal interest rate.
- “Inflation makes everyone poorer.” Unexpected inflation redistributes purchasing power. Borrowers and employers paying fixed wages gain what lenders and workers lose.
- “Deflation is good for everyone because things get cheaper.” Unexpected deflation hurts borrowers, because debts fixed in money become harder to repay.
- “Borrowers lose from inflation because prices go up.” A borrower with a fixed-rate loan gains from unexpected inflation, because the fixed repayment is worth less.
- “A saver earning interest is protected from inflation.” Only if the interest rate is above the inflation rate that actually happens. In Worked example 2, 2% interest did not cover 10% inflation.
- Using the wrong ratio. To find what a later amount is worth in earlier money, multiply by (earlier CPI ÷ later CPI), not the other way round.
Where this leads
Next, Topic 2.6, Real v. Nominal GDP, uses a price index to remove inflation from GDP. In Topic 4.2 you will formalise the link between nominal interest rates, expected inflation and real interest rates. First try the practice questions, then use the revision notes and the checklist to consolidate.
Quick questions
Does inflation always hurt lenders?
No. If lenders correctly expect the inflation, they build it into the nominal interest rate and still earn the real return they wanted. Lenders lose when inflation turns out higher than they expected.
Do I need to calculate real interest rates in this topic?
Not formally. Here you explain who gains and loses, and you can show it by finding the purchasing power of a repayment with a price index. Defining and calculating nominal and real interest rates is Topic 4.2.