How inflation affects savers, lenders and borrowers

Government and the Macro‑economy – Inflation

Objective

Explain how inflation affects savers, lenders and borrowers.

Key concepts

• Inflation – a sustained increase in the general price level.
• Nominal interest rate (i) – the rate quoted by banks.
• Real interest rate (r) – the purchasing‑power return on money.
• Formula: \$r = i - \pi\$ where \pi is the inflation rate.
• Redistributive effect – inflation can change the real distribution of income and wealth.

Effect on Savers

Savers deposit money in banks or hold cash expecting a return. When inflation rises:

1. The purchasing power of the saved amount falls if the nominal interest earned is lower than inflation.
2. Real return becomes negative: \$r = i - \pi < 0\$.
3. To preserve value, savers may seek higher‑yielding assets (e.g., index‑linked bonds, property).
4. In an environment of high inflation, the incentive to save decreases, potentially reducing the pool of funds available for investment.

Effect on Lenders

Lenders provide funds and expect to be repaid with interest. Inflation influences them in two ways:

1. Nominal interest rates tend to rise as lenders demand compensation for the loss of purchasing power.
2. If the increase in nominal rates does not keep pace with inflation, the real return to lenders falls, eroding profitability.
3. Lenders may tighten credit standards or increase collateral requirements to protect against real losses.

Effect on Borrowers

Borrowers repay loans with interest. Inflation can be advantageous for them when:

1. The real interest rate is low or negative, meaning they repay with money that is worth less than when they borrowed.
2. Fixed‑rate borrowers benefit most, as the nominal repayment amount stays unchanged while inflation reduces its real value.
3. Variable‑rate borrowers may see repayments rise if lenders raise nominal rates to offset inflation.
4. Overall, moderate inflation can stimulate borrowing and investment, but high or volatile inflation creates uncertainty and may deter long‑term projects.

Summary Table