How inflation affects savers, lenders and borrowers

Government and the Macro‑economy – Inflation

Objective

Explain how inflation affects savers, lenders and borrowers, and understand the related macro‑economic concepts and policy responses required by the Cambridge IGCSE 0455 syllabus.

Key concepts

• Inflation – a sustained increase in the general price level of goods and services.
• Deflation – a sustained decrease in the general price level; the opposite of inflation and usually associated with falling demand, lower output and higher unemployment.
• Consumer Prices Index (CPI) – measures the average price change of a fixed “basket” of goods and services bought by a typical household.

  • Current CPI = (Cost of basket in current year ÷ Cost of basket in base year) × 100.
  • Inflation rate = (CPI_{this year} – CPI_{last year}) ÷ CPI_{last year} × 100 % (percentage change in the CPI).

• Causes of inflation

  • Demand‑pull inflation: excess aggregate demand over aggregate supply (e.g., high consumer confidence, expansionary fiscal policy).
  • Cost‑push inflation: rising input costs such as wages, raw‑material prices or import prices force firms to raise selling prices.

• Nominal interest rate (i) – the rate quoted by banks or lenders, not adjusted for price changes.
• Real interest rate (r) – the purchasing‑power return on money.

  
  Formula: r = i – π where π is the inflation rate.

• Redistributive effect of inflation – inflation changes the real distribution of income and wealth because it benefits those with fixed‑rate debt (borrowers) and harms those whose income is mainly cash‑based or who hold cash savings.

Measurement recap

Example: if the CPI was 120 last year and 126 this year, the inflation rate is (126‑120)/120 × 100 % = 5 %.

Consequences of inflation (and deflation)

• Consumers – real purchasing power falls when prices rise faster than wages.
• Workers – if wages do not keep up with inflation, real wages fall; a wage‑price spiral can develop.
• Firms – higher input costs reduce profit margins unless firms can pass the rise on to customers; uncertainty may delay investment.
• Overall economy – high inflation can distort price signals, reduce savings, increase uncertainty and potentially lower economic growth, raise unemployment and affect the balance of payments.
• Deflation – falling prices usually reflect weak demand, leading to lower output, higher unemployment and a possible debt‑deflation spiral. The same policy tools (tight monetary policy, contractionary fiscal policy, supply‑side measures) are used to stabilise the price level.

Effect on Savers

Savers keep money in cash, bank deposits or low‑risk assets expecting a return.

1. If the nominal interest earned (i) is lower than the inflation rate (π), the purchasing power of the saved amount falls.
2. Real return becomes negative: r = i – π < 0.
3. To preserve value, savers may:

   • Move to higher‑yielding or inflation‑linked assets (index‑linked bonds, property, equities).
   • Demand higher nominal rates on deposits.

4. High inflation reduces the incentive to save, shrinking the pool of funds available for investment.
5. Household budgets are squeezed because wages often rise more slowly than prices, leaving less disposable income to save.

Effect on Lenders

Lenders provide funds and expect to be repaid with interest.

1. Nominal interest rates tend to rise as lenders demand compensation for the loss of purchasing power.
2. If the rise in i does not keep pace with inflation, the real return r falls, eroding profitability.
3. To protect against real losses, lenders may:

   • Raise the quoted nominal rate.
   • Require higher collateral or tighter credit standards.
   • Prefer variable‑rate loans that can be adjusted as inflation changes.

Effect on Borrowers

Borrowers repay loans with interest.

1. When the real interest rate is low or negative, borrowers repay with money that is worth less than when they borrowed.
2. Fixed‑rate borrowers benefit most because the nominal repayment amount stays unchanged while inflation reduces its real value.
3. Variable‑rate borrowers may see repayments rise if lenders increase nominal rates to protect their real return.
4. Moderate inflation can stimulate borrowing and investment, but high or volatile inflation creates uncertainty and may deter long‑term projects.
5. Wage earners may find debt repayment more burdensome if real wages fall.

Numerical examples

Positive real return – Nominal rate 6 %, inflation 4 %:

r = 6 % – 4 % = 2 % → saver’s purchasing power rises by 2 % per year.

Negative real return – Nominal rate 5 %, inflation 7 %:

r = 5 % – 7 % = –2 % → saver loses 2 % of purchasing power each year.

Summary table

Policies to control inflation (syllabus wording)

• Monetary policy – tightening: raising the policy interest rate or reducing the money supply.

  
  Effect: higher nominal rates discourage borrowing, reduce aggregate demand and slow price rises.

  
  Evaluation: usually effective in the short‑run, but can increase unemployment and slow growth.

• Fiscal policy – contractionary: increasing taxes or cutting government spending.

  
  Effect: reduces disposable income and aggregate demand, helping to lower inflation.

  
  Evaluation: can reinforce monetary policy but is slower to implement and politically difficult.

• Supply‑side measures: improving productivity, reducing import duties, encouraging competition.

  
  Effect: shifts aggregate supply to the right, easing cost‑push pressures.

  
  Evaluation: important for long‑run price stability but takes time to deliver results.

Link to the four macro‑economic aims

• Economic growth – price stability preserves the real value of income and savings, encouraging investment and sustainable growth.
• Full employment – moderate, predictable inflation helps avoid the deflationary spiral that can raise unemployment.
• Stable prices – directly achieved by the above policies; it protects households and firms from uncertainty.
• Balance of payments stability – low inflation reduces pressure on the exchange rate, helping to avoid large deficits or surpluses.

Suggested diagram