If wages increase with inflation, and if the borrower already owed money before the inflation occurred, the inflation benefits the borrower. This is because the borrower still owes the same amount of money, but now he or she has more money in his or her paycheck to pay off the debt. This results in less interest for the lender if the borrower uses the extra money to pay his or her debt early.
Causes of Inflation
When looking at the inflation rate for an entire economy, most economists agree that the long-term effects of inflation depend on the money supply. In other words, the money supply has a direct, proportional relationship with price levels. Thus, if the currency in circulation increases, there is a proportional increase in the price of goods.
To get a clearer picture of how inflation works, imagine that tomorrow, every single person’s bank account and salary doubled. Initially we might feel twice as rich as we were before, but prices would quickly rise to catch up to the new status quo. Before long, inflation would cause the real value of our money to return to its previous levels. Thus, increasing the supply of money increases the price levels. This idea is known as the quantity theory of money.
- Inflation allows debtors pay lenders back with money that is worth less than it was when it was originally borrowed.
- When inflation causes higher prices, the demand for credit increases (which benefits lenders), especially if wages have not increased.
Inflation Helps Borrowers
When a business borrows money, the cash it receives now will be paid back with cash it earns later. A basic rule of inflation is that it causes the value of currency to decline over time. In other words, cash now is worth more than cash in the future. Thus, inflation lets debtors pay lenders back with money that is worth less than it was when they originally borrowed it.
Inflation Also Helps Lenders
Inflation can help lenders in several ways, especially when it comes to extending new financing. First, higher prices mean that more people want credit to buy big-ticket items, especially if their wages have not increased – new customers for the lenders. On top of this, the higher prices of those items earn the lender more interest. For example, if the price of a TV goes from $1,500 to $1,600 due to inflation, the lender makes more money because 10% interest on $1,600 is more than 10% interest on $1,500. Plus, the extra $100 and all the extra interest might take more time to pay off, meaning even more profit for the lender.
Second, if prices increase, so does the cost of living. If people are spending more money to live, they have less money to satisfy their obligations (assuming their earnings haven't increased). This benefits lenders because people need more time to pay off their previous debts, allowing the lender to collect interest for a longer period. However, the situation could backfire if it results in higher default rates.