💰 Savers
Savers lose when inflation is higher than the interest rate they earn. Money kept under the bed earns no interest at all, so it loses value every year that prices rise.
Inflation » Consequences of Inflation
What you'll learn this session
Study time: 30 minutes
Cambridge spec: 4.7.4
- How inflation affects savers, lenders and borrowers
- What a real interest rate tells you
- How inflation affects consumers, workers, firms and the whole economy
- A quick look at why deflation can also cause problems
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Unlock This CourseWho gains and who loses?
Inflation does not hit everyone in the same way. Some people lose out, some are barely touched, and a few even gain. The key question is always: does my income or my money keep up with rising prices?
Think of the cost of living. If prices rise by 5% but your pocket money stays the same, you can buy less than before. Your money has lost purchasing power.
Key terms:
- Purchasing power: the amount of goods and services a unit of money can buy.
- Real interest rate: the interest rate after taking inflation into account. Real interest rate = interest rate - inflation rate.
- Fixed income: an income that stays the same even when prices rise, for example a pension that is not increased.
Savers, lenders and borrowers
The interest rate you see advertised is the money rate. The real interest rate tells you what you truly gain or lose once prices have risen.
Worked example
Hana in Kelmar puts $1,000 in a bank account paying 3% interest. Inflation is 5%.
Real interest rate = 3% - 5% = -2%.
After one year she has $1,030, but prices have risen by 5%, so her $1,030 buys less than her $1,000 did before. Her savings have lost purchasing power. If inflation was only 1%, her real interest rate would be +2% and she would gain.
🏦 Lenders
A lender is repaid with money that buys less than the money lent. If a bank lends $10,000 at a fixed 4% and inflation is 6%, the real interest rate is -2%. The lender loses.
💳 Borrowers
Borrowers gain when inflation is higher than the interest rate they pay. They repay with money that is worth less than when they borrowed it. The same debt becomes easier to pay back.
📝 The catch
This is mainly true when inflation is unexpected. If lenders expect high inflation, they usually charge higher interest rates to protect themselves.
Consequences for consumers and workers
Consumers find that their money buys less, so their standard of living falls if their income does not rise as fast as prices. People on a fixed income, such as some pensioners, are hit hardest. Consumers who expect prices to keep rising may also buy goods sooner rather than later.
Workers need pay rises just to stay in the same position. If wages rise by 3% while prices rise by 5%, workers' real wages have fallen. Workers with strong trade unions may win bigger pay rises, while those in weak bargaining positions fall behind. Pay rises won to keep up with prices can also push up firms' costs, which can feed further inflation.
Consequences for firms
- Higher costs: wages, raw materials and energy may all cost more. If firms cannot pass these on, profits fall.
- Uncertainty: when prices keep changing, firms find it hard to plan. They may delay investment in new machines or buildings because they cannot be sure what costs and sales will be.
- Menu costs: the cost of changing prices, such as reprinting price lists.
Inflation also brings shoe leather costs: the time and effort people spend protecting their money from inflation, such as searching for the best interest rate or the cheapest shop.
Some firms may gain if the price they charge rises faster than their costs. Firms that borrowed money also benefit from the falling real value of their debt.
Consequences for the economy
Inflation can damage the whole economy. Higher inflation causes uncertainty, which discourages spending and investment and may reduce economic growth. It can also reduce international competitiveness: if prices rise faster at home than in other countries, exports become more expensive for foreign buyers and imports look cheaper to home buyers. The country may sell fewer exports and buy more imports.
Common mistakes
Saying that inflation is always bad for everyone. Borrowers can gain, and some firms gain if their prices rise faster than their costs.
Forgetting the real interest rate. A saver earning 2% when inflation is 4% is losing, not gaining.
Describing "prices rise" as the whole answer. Always say who is affected and why, such as "wages do not keep up, so real income falls".
A brief look at deflation
Deflation can cause problems too. If consumers expect prices to fall, they may delay spending, so sales and firms' revenue fall and firms may cut jobs. Falling prices also make debts harder to repay, because borrowers repay with money that is worth more. This hurts borrowers and gains savers and lenders.
Exam-style question
In Arvenia, the government reports that prices rose by 6% last year. Bank savings accounts paid 4% interest. Many pensioners live on a fixed income. Several exporters said their goods were less competitive abroad.
(a) Calculate the real interest rate on a savings account paying 4% when inflation is 6%. [2]
(b) Explain two ways inflation may harm firms. [4]
(c) Discuss whether inflation affects all people in Arvenia in the same way. [6]
Model answer
(a) Real interest rate = 4% - 6% (1) = -2% (1).
(b) Costs such as wages and raw materials rise (1), which reduces profits if firms cannot raise prices (1). Uncertainty about future prices makes planning hard (1), so firms may delay investment (1). Other valid points: menu costs, or exports becoming less competitive.
(c) Inflation does not affect everyone in the same way. Pensioners on a fixed income lose purchasing power (1) because their income does not rise with prices (1). Savers earning less than the inflation rate lose (1). Borrowers with fixed-rate loans may gain, as they repay with money that is worth less (1). Workers whose pay rises with prices stay the same, while those without pay rises lose (1). So inflation harms some groups but can help others (1).
Exam tip
In a "Discuss" question, show both sides: name a group that loses and a group that may gain, and say why.