Effects of inflation — who wins and who loses

Two neighbours, one inflation

Rosa and Tendai (invented) live on the same street. At the start of a year, Rosa puts $50 000 of savings in a bank account that pays 1% interest. On the same day, Tendai borrows $50 000 to buy a small flat. He agrees to repay it, with 3% interest, at the end of the year.

During the year, prices rise by 10%. Nobody expected it.

At the end of the year, Rosa has $50 500. But prices are 10% higher, so her money buys only what $50500÷1.10\approx 45909$ dollars bought at the start. She has lost about $4 091 of buying power, and she did nothing wrong. Tendai repays $51 500. In start-of-year prices, that is worth only about $46 818. He borrowed $50 000 of buying power and paid back less than that.

Many people say that inflation makes everyone poorer. This example shows something different: inflation quietly moves buying power from some people to others. The last lecture promised to ask who gains and who loses. This lecture answers it, and explains why.

Money amounts and buying power

The lecture on real and nominal GDP separated an amount of money from what it can buy. The same idea works for savings, a debt, a wage or a pension. With a price index whose base period is 100:

Suppose the price index rises from 100 to 125. Then $10 000 buys what $10000÷125\times 100=8000$ dollars bought in the base period. Its buying power has fallen by a fifth.

Now apply this to interest. The interest rate written on a savings account or a loan is the nominal interest rate. What matters to a saver is the real interest rate: how much more the money can buy after a year. As in the GDP lecture, you divide growth factors.

Rosa's account: $1.01÷1.10\approx 0.918$. So her real interest rate was about $-8.2\%$. The shortcut "nominal rate minus inflation" gives $1\%-10\%=-9\%$. The shortcut is close when the rates are small, and it gets worse as they grow.

Lenders lose, borrowers gain

Look again at Tendai. A debt is a promise to pay a fixed amount of money. Inflation does not change the amount, but it does change what the amount is worth. So when prices rise, every debt written in money shrinks in real terms.

Suppose someone owes $200 000 for five years, and prices rise by 5% each year. After five years the price level is $1.05^5\approx 1.276$ times higher. So the $200 000 is worth only about $200000÷1.276\approx 156700$ dollars in the prices of the first year. The borrower pays nothing extra, and the real debt is about $43 000 smaller.

Every debt has two sides. What the borrower gains, the lender loses. The buying power moves from the people who are owed money to the people who owe it. That is why economists say that inflation redistributes income and wealth.

The surprise is what moves the money

This is the hard part of the lecture. Spend time here. If inflation always helps borrowers, why would anyone lend?

The answer is that lenders are not foolish. Suppose a lender wants to earn 3% a year in real terms, and everyone expects 10% inflation. Then the lender will ask for about $1.03\times 1.10-1=13.3\%$ interest. If inflation does turn out to be 10%, the real interest rate is exactly the 3% both sides planned. Nobody gains and nobody loses. This idea, that the nominal interest rate includes the inflation people expect, is named after the American economist Irving Fisher.

So it is not inflation itself that moves buying power. It is unexpected inflation: the gap between the inflation people planned for and the inflation that happened. Rosa and Tendai lost and gained because 10% was a surprise. Try the gap yourself.

What should you have seen? Whenever the two sliders matched, the lender got exactly the planned $11 041 of buying power, however high inflation was. When inflation was higher than expected, the borrower gained. When it was lower, the lender gained. That is it. That is the whole idea of this lecture. Inflation moves buying power when an amount is fixed in money and the inflation was not expected.

Who else loses: fixed incomes, slow pay and cash

The same idea, an amount fixed in money, explains the other losers.

Workers whose pay rises late. Pay is usually agreed once a year. When prices jump between pay rises, real pay falls. In the United Kingdom, average regular pay fell by 3.0% in real terms in the year to April–June 2022, the largest fall since comparable records began in 2001 (ONS, August 2022). The fall was not shared equally. In July–September 2022, regular pay grew by 6.6% in the private sector but by only 2.2% in the public sector (ONS, November 2022). Workers whose pay was set slowly fell further behind.

People on benefits and pensions with a time lag. The measuring-inflation lecture showed that UK benefits rise each April with the CPI of the September before. In April 2022 they rose by 3.1%, the CPI rate for September 2021, while CPI inflation was 9.0% (DWP, 2022 and 2023). For a year, their real value fell. In April 2023 they rose by 10.1% and caught up. Indexation protected these households in the end, but the lag left them a year behind.

People holding cash. Notes and coins earn no interest, so cash loses buying power at the rate of inflation. People respond by holding less cash and moving money more often. Economists call this effort the shoe-leather cost, from the picture of walking to the bank more often.

Who gains? Borrowers with fixed-rate debts, as long as their incomes keep up with prices. Owners of houses often see their prices rise with inflation. And one borrower is larger than all the rest.

The largest borrower of all: the government

Governments borrow by selling bonds. A bond with a fixed interest rate is a debt fixed in money. So unexpected inflation cuts the real value of government debt, and the people who hold the bonds pay for that gain.

There is an exception, and the UK in 2022 shows it. About a quarter of UK government debt, £503.7 billion in March 2022, was in index-linked gilts (ONS). These bonds pay interest, and repay their value, in line with the RPI. In June 2022 the interest the UK government owed on its debt was £19.4 billion in a single month. That was the highest since monthly records began in 1997, and £16.7 billion of it came from the rise in the RPI (ONS, July 2022). On index-linked debt, inflation gives the government no gain at all. The lenders are protected, so the cost stays with the government.

Sort the cases below, using one test for each: is the amount fixed in money, and was the inflation expected?

Tax that rises without a vote

Income tax is usually charged on income above a threshold. If the threshold is a fixed amount of money, inflation raises taxes by itself. Pay rises with prices, so more of each person's income is above the threshold, and more people cross into higher tax bands. Their real income has not grown, but their real tax bill has. This is called fiscal drag, or "bracket creep".

A real case: freezing tax thresholds (UK, 2021 onwards)

The policy. In March 2021 the UK government froze the income tax personal allowance at £12 570 and the higher-rate threshold at £50 270, from 2022–23 to 2025–26. By law these amounts normally rise with inflation each year.

The prediction. The Office for Budget Responsibility (OBR) estimated that the freeze would raise about £8.2 billion in 2025–26, and bring about 1.3 million more people into income tax (OBR, March and October 2021). That forecast assumed low inflation: 1.9% in 2022–23 (IFS, 2026).

What happened. Inflation in 2022–23 reached 10.0% (IFS, 2026). The higher inflation and pay growth made the same freeze far larger. The freeze was extended, first to 2027–28 and then to 2030–31. By November 2025 the OBR estimated the effect of all the threshold freezes since 2022–23. By 2030–31 they would bring 5.2 million more people into income tax, and move 4.8 million more into the higher rate (OBR, November 2025). In 2026–27, the allowance would be £16 070 if it had risen with inflation since April 2021 (IFS, August 2026).

The verdict. A frozen threshold is a tax rise whose size is decided by inflation, not by a vote. With low inflation the freeze was modest. When inflation surprised everyone, the same decision became one of the largest tax rises in decades. Unexpected inflation moved buying power from taxpayers to the government.

Costs that do not move to anyone

Not every effect of inflation is a transfer. Some are pure losses, where nobody gains.

• Menu costs. Firms spend time and money changing prices: price lists, websites, labels and computer systems. Each change is small, but across a whole economy it adds up.
• Shoe-leather costs. Time spent managing money to avoid holding cash.
• Uncertainty. When future prices are hard to predict, lenders ask for extra interest to cover the risk. Firms find it harder to judge whether an investment will pay, so they invest less, and capacity grows more slowly.

There is also an effect on trade. If a country's prices rise faster than its trading partners' prices, its goods become dearer abroad.

When money stops working: hyperinflation

At very high rates, inflation stops being a transfer and becomes a collapse. Economists usually call it hyperinflation when prices rise by more than 50% in a month.

In Germany, prices rose by about 29 500% in October 1923 alone, so they doubled about every 3.7 days (Hanke and Krus). Savings built over a lifetime became worthless, and debts could be repaid with almost worthless paper. A new currency was introduced in November 1923.

In Zimbabwe, the peak came in mid-November 2008, with an estimated monthly rate of 79.6 billion per cent (Hanke). Prices doubled about every day. In 2009 the country stopped using its own currency, and people used foreign currencies, such as the US dollar, instead.

Both cases had the same root. A government paid its bills by creating money, and people stopped believing the money would keep its value. Then buying power is not moved from one group to another. It is destroyed.

Three classic mistakes