In a typical economy, what is one effect of inflation on different groups in society?

• A. It increases the real value of fixed nominal debts, making borrowers better off and lenders worse off.
• B. It leaves the purchasing power of money unchanged, so it has no distributional effects across households.
• C. It reduces the real purchasing power of people living on fixed nominal incomes if their income does not rise as fast as prices.
• D. It guarantees that all wages rise automatically at the same rate as prices, so no one is harmed.

Answer: (C)

Verified step by step guidance

1. Step 1: Understand the concept of inflation, which is the general increase in prices across the economy over time, leading to a decrease in the purchasing power of money.
2. Step 2: Recognize that inflation affects different groups differently, especially those with fixed nominal incomes, such as retirees or workers with fixed wages, because their income does not automatically adjust with rising prices.
3. Step 3: Analyze how inflation reduces the real purchasing power of people on fixed nominal incomes if their income does not increase at the same rate as prices, meaning they can buy less with the same amount of money.
4. Step 4: Contrast this with borrowers and lenders: inflation decreases the real value of fixed nominal debts, benefiting borrowers (who repay with less valuable money) and harming lenders (who receive less valuable repayments).
5. Step 5: Conclude that the correct effect of inflation in this context is that it reduces the real purchasing power of people living on fixed nominal incomes if their income does not rise as fast as prices, causing a distributional effect across society.