Question

True or False. Lenders are helped by unanticipated inflation.

Short answer

The statement is false.

Step-by-step solution

Redistribution effect of inflation

Inflation is the increase in the general price level. When the general price level rises, the purchasing power of money decreases. This leads to a decrease in the real income (interest payment) of the lenders. The real income shifts from lenders to borrowers involved in the transaction. This shift of real income is called the redistribution effect. Only unanticipated changes in inflation can result in a redistribution effect.

Reason for the false statement

If people can anticipate inflation, they can secure their real income from losing. When inflation is unanticipated, it benefits some individuals and hurts others because of the redistribution effect.

If the lenders cannot anticipate the inflation, the real income (interest rate) earned by them becomes lower than before. This happens because the currency's value decreases due to inflation, and the agreed nominal interest rate (which was fixed when the loan was given) loses its value. Their real income is shifted to the debtors.

For example, suppose John agrees to lend $10,000 to Daisy at an interest of 7% per annum. Accordingly, she will have to pay $700 at the end of the year as an interest amount. This is his real income.

Suppose the inflation rate increases by 3 %, the real interest rate (the real income) that John will receive will be 4 %. John will get a $400 real income value (nominal income would still be $700). This is the result of unanticipated inflation.

If John anticipates a 3 % inflation rate, he will adjust the nominal interest rate and charge 10 % to cover the loss of value due to inflation.

Thus, lenders are not helped by unanticipated inflation; it helps the borrowers as the value of interest payment decreases in real terms.