Who is Affected by Inflation?: Videos & Practice Problems

Inflation, defined as a general increase in price levels, impacts various economic participants differently. Fixed income receivers, such as retirees, face reduced purchasing power as their income remains constant while prices rise. Savers, especially those hoarding cash, see their savings erode in value. Conversely, debtors benefit from inflation, as they repay loans with money that has less purchasing power. Flexible income receivers, like those with cost of living adjustments, remain unaffected. Understanding these dynamics is crucial for grasping the broader implications of inflation on the economy.

Who is Affected by Inflation?

So now let's discuss how inflation affects different members of the economy. So remember, inflation, just like we've been discussing, is an increase in prices, right? It's a general increase in the price level. So something cost $100 last year, and now it's $105. It is increasing in 2 types of inflation. We can anticipate the inflation. We can expect what's going to happen. Oh, the price levels are going to increase by about 2%. We can expect in the next year, and that's going to be an estimate of the amount of inflation that's going to occur. We're estimating in the next year, we're expecting 2% inflation something like that. However, a problem arises when we have unanticipated inflation. What if we were expecting 2% inflation and now there's 5% inflation, 6% inflation, right? That can cause problems to different people in the economy.

Let's start with the people who get hurt by this unanticipated inflation, People who do not like unanticipated inflation. The first one is fixed income receivers. So imagine, if you're earning a fixed income, your salary is staying the same. Let's say your salary is $50,000, well, that is going to be your salary regardless of the price level, right? If your inflation if your, salary is not changing, but the prices are going up, that's gonna suck for you. So, some examples of some fixed-income receivers are retired people that have like a pension that they're just living off a pension. That pension is not going up over time, and the prices are going up over time. So their purchasing power falls and landlords that receive fixed lease payments. So if someone's renting out an apartment, but they're not increasing the rent year after year, they're keeping the rent stable, well, they're going to be hurt by these inflate by this inflation and the rising prices, okay? So if the nominal income is constant, think about it. Your nominal income is constant while prices are rising, well, what's happening to your real income? What happens to your purchasing power? It decreases, right? Because your nominal income, the dollars that you're receiving are staying the same, but the prices of everything are going up, so the real income goes down. We can think of real income as kind of like that purchasing power.

Next person who's hurt by unanticipated inflation here is a saver. Someone who's saving money and basically the rising prices, the inflation is going to hurt the savings. Just like we saw when we calculated nominal interest and real interest, well you're not getting exactly what that nominal interest rate is because of the inflation, right? You're getting a little less, the real interest rate. Now someone who's really hurt by it is someone who's hoarding cash like someone who puts cash under their mattress. Well, that cash isn't earning any interest, right? It's just sitting there and it's the same amount of cash being saved all the time and you're not earning any interest, but those price levels are going up, Okay? So notice what happens here. Someone who had been hoarding cash between 1985 and 2009 would have lost half its value by not getting any interest, but those price levels increasing. So that's pretty significant there. Now, even if you're earning interest just like I said, if you're earning interest in a bank account, the real interest rate will fall and if you want more information there, well, you can reference this video nominal interest, real interest, Fisher equation, right? And we discussed how inflation affects those interest rates. The last big group here hurt by inflation are creditors. So creditors are people who loan out money, right? So inflation is going to cause the principal what they get repaid. So let's say I loan you a $1,000 today and you're going to pay me some interest, right? I expected inflation, you know, to be 2%. So, I calculated that into my calculation of what I was going to charge you interest. However, inflation ends up being 10% or something way higher than I expected and when you repay me that $1,000 that money I loaned you had more purchasing power than it did now, right? The $1,000 I loaned you was able to buy more because inflation now makes that purchasing power less of the $1,000 you repaid me, okay? So the creditor is hurt. So, right? First Bank loans a $1,000. There's unanticipated inflation. 5 years later, when they receive that $1,000 back, well, it's not worth as much as when they loaned it. Cool? Alright. Let's talk about some people who are helped or simply just not affected by inflation. So someone generally not affected here would be a flexible income receiver. So someone who gets paid flexible income and generally, this is people with cost of living adjustments. So cost of living adjustment, it could be in their contract, and this comes up a lot. Oh, I have it written here. Union contracts generally have a cost of living adjustment in the contract, that adjusts for inflation. So it could say in the contract, hey, the salary is $50,000, but each year, the salary needs to be in the contract. So Another one is Social Security payments. So Social Security, the payments of Social Security also have a cost of living adjustment built into them. So they and inflation doesn't really affect you because your income's going up based on that inflation as well. Someone who gets helped here well is a debtor on the opposite side of the creditor example that we just talked about who's hurt. Well, the person who borrowed the money is going to be helped, right? Because the inflation is going to cause the balance to have less purchasing power when they repaid it. So Bob borrows $1,000 from the bank right now. There's a bunch of inflation and later on he has to pay back the 1,000 that has less purchasing power in the future. He might be able to earn it a little easier, that $1,000 he's repaying. Okay? So that's an interesting thing to think about when we deal with inflation because we generally in our head are thinking, oh, inflation is a bad thing. But there's actually two sides to the issue there. Cool? Alright. Not much more to say about this. Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

How does inflation affect fixed income receivers?

Inflation negatively impacts fixed income receivers, such as retirees living on pensions. Since their income remains constant while prices rise, their purchasing power diminishes. For example, if a retiree receives a fixed annual pension of $50,000, but inflation causes prices to increase by 5%, the real value of their pension decreases. This means they can buy less with the same amount of money, effectively reducing their standard of living. Understanding this dynamic is crucial for grasping the broader implications of inflation on different economic participants.

Why are savers hurt by inflation?

Savers are hurt by inflation because the value of their saved money decreases over time. If someone saves money in a bank account with a nominal interest rate, the real interest rate they earn is reduced by the inflation rate. For instance, if the nominal interest rate is 3% and inflation is 2%, the real interest rate is only 1%. This erosion of value is even more pronounced for those hoarding cash, as it earns no interest at all. Therefore, inflation reduces the purchasing power of their savings, making it harder to achieve financial goals.

How do debtors benefit from inflation?

Debtors benefit from inflation because they repay loans with money that has less purchasing power than when they borrowed it. For example, if Bob borrows $1,000 and inflation rises significantly, the $1,000 he repays in the future will be worth less in real terms. This means that the real value of his debt decreases, making it easier for him to repay. Essentially, inflation reduces the burden of debt, which can be advantageous for borrowers.

What is the impact of inflation on creditors?

Inflation negatively impacts creditors, who are individuals or institutions that lend money. When inflation is higher than anticipated, the money repaid to them has less purchasing power than the money they originally lent out. For instance, if a bank loans $1,000 expecting 2% inflation but the actual inflation rate is 10%, the real value of the $1,000 repaid is significantly lower. This erodes the real return on their loan, making lending less profitable.

Who remains unaffected by inflation and why?

Flexible income receivers, such as those with cost of living adjustments (COLAs) in their contracts, remain unaffected by inflation. These adjustments ensure that their income increases in line with inflation, maintaining their purchasing power. For example, union contracts and Social Security payments often include COLAs, which automatically adjust salaries or benefits to match inflation rates. This mechanism helps protect their real income, ensuring that they can maintain their standard of living despite rising prices.