The effects depend on income adjustment, contracts and expectations.
Inflation can reduce purchasing power when nominal income fails to keep pace with relevant prices. Unexpected inflation can redistribute real wealth between parties to fixed nominal contracts: the real value of a fixed repayment falls, benefiting the borrower relative to the lender in that respect. This does not guarantee the borrower can afford the payment if earnings fail to keep pace. Savers' outcomes depend on nominal returns and asset types. High or uncertain inflation can obscure relative-price signals, complicate planning and raise repricing costs. Competitiveness also depends on foreign inflation, exchange rates, productivity and quality, not domestic inflation alone.
- Purchasing power
- Purchasing power is what money can buy. Nominal income is the amount received in money; real income allows for prices. If a person's income rises more slowly than the prices they face, purchasing power falls.
- Contracts
- A fixed nominal repayment is an unchanged money amount. Unexpected inflation makes that amount buy less. An indexed payment instead adjusts according to an agreed price index; contracts that anticipated inflation may also offer a different money return.
- Uncertainty
- Unstable prices make future costs and receipts harder to predict. That can complicate saving, investment and business planning.
Different incomes and contracts, different effects
Firms
Profit is sales revenue minus costs. Changing price lists and managing cash use time and resources; higher selling prices do not guarantee more profit if costs also rise.
Competitiveness
Compare domestic with foreign inflation, exchange rates, productivity and product quality.
Distribution
Fixed-income recipients, workers, savers, borrowers and lenders can face different effects; specify contract and income conditions.
Price signals
A relative price compares one product with others. When many prices change unpredictably, a firm may find it harder to tell whether its own price increase signals stronger demand for its product or simply general inflation.
Savers
Interest and changes in an investment's value affect the money return from saving. Compare that return, including any price-linked adjustment, with the prices faced. Cash and different investments need not have the same purchasing-power outcome.
Worked example: A fixed pension and a fixed loan repayment
A pension is fixed at $1,000 and a relevant consumer basket initially costs $100. The basket later costs $110 while the pension is unchanged. A separate loan promises a fixed $1,100 repayment; neither contract adjusts for the unexpected price rise.
- The pension buys $1,000 / $100 = 10 baskets initially, but $1,000 / $110 is about 9.09 baskets later. Its money amount is unchanged while its purchasing power falls.
- The fixed repayment buys $1,100 / $100 = 11 baskets initially and $1,100 / $110 = 10 later. The lender receives money worth fewer goods; the borrower repays less in this purchasing-power sense.
- The borrower's cash repayment remains $1,100. Ability to pay still depends on earnings and other commitments.
- If contracts had anticipated inflation through higher nominal returns or indexation, the redistribution could differ. Do not state that every saver loses or every debtor becomes better off overall.
Watch out for this
Inflation guarantees that all borrowers are better off and all firms earn more profit.
Contract terms, expectations, income changes, demand and costs differ. Specify the mechanism and whose outcome is measured.
Check your understanding
A fixed pension is unchanged while the relevant basket price rises. What happens to the pension's purchasing power?
- It necessarily rises because nominal income is constant.
- It is unchanged by definition.
- It falls.