Inflation occurs when there is a general increase in the price of goods and services and a fall in purchasing power. Purchasing power is the value of a currency expressed in terms of the number of goods and services that one unit of the currency can purchase.

Many 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 in the long term. Thus, if the currency in circulation increases, there is a proportional increase in the price of goods and services.

For example, imagine that tomorrow, every single person’s bank account and their salary doubled. Initially, we might feel twice as rich as we were before, but the prices of goods and services would quickly rise to catch up to this new wage rate.

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. Inflation can benefit either the lender or the borrower, depending on the circumstances.

Key Takeaways

  • Inflation occurs when there is a general increase in the price of goods and services, which leads to a fall in the purchasing value of money.
  • Inflation can benefit both borrowers and lenders, depending on the circumstances.
  • The money supply can directly affect prices; prices may increase as the money supply increases, assuming no change in economic output.
  • Inflation allows borrowers to pay lenders back with money worth less than when it was originally borrowed, which benefits borrowers.
  • When inflation causes higher prices, the demand for credit increases, raising interest rates, which benefits lenders.

Inflation and the Quantity Theory of Money

In the long run, the best way to think about money and inflation is with the quantity theory of money MV=PQ where M is money supply, V is the velocity of money, P is the general price level, and Q is the real output of the economic system or gross domestic product (GDP) in real terms. Then solving the quantity theory for P gives P=MV/Q.

If V is assumed relatively constant, then P or prices will increase if the money supply increases faster than real output. In the short run, such as overnight, when the real output does not change, prices will likely increase proportionally with the money supply. However, in the long run, the increase in real output should ameliorate the increase in prices. In other words, over the long term, increasing the supply of money faster than the growth in real output can lead to inflation.

If we apply the P=MV/Q formula to the earlier example of salaries and bank accounts doubling in an economy, M doubling with no corresponding increase in output Q (assuming constant V) would lead to a doubling of P or prices.

Factors that Increase Money Supply

Aside from printing new money, various other factors can increase the money supply within an economy. Interest rates may be reduced, or the reserve ratio for banks may be reduced (the percentage of deposits the bank keeps in cash reserves).

Lower rates and reserves held by banks would likely lead to an increased demand for borrowing at lower rates, and banks would have more money to lend. The result would be more money in the economy, leading to increased spending and demand for goods, causing inflation.

A Central Bank, such as the Federal Reserve Bank (Fed), may buy government securities or corporate bonds from bondholders. The result would be an increase in cash for the investors holding the bonds, leading to an increase in spending. The policy of a central bank, such as the Fed, buying corporate bonds would also lead to corporations issuing new bonds to raise capital to expand their businesses, leading to increased spending and business investment.

Inflation Can Help Borrowers

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 they more money in their paycheck to pay off the debt. This results in less interest for the lender if the borrower uses the extra money to pay off their debt early.

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 a 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 Can Also Help 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–this equates to 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 television increases 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.

Inflation and the Cost of Living

If prices increase, so does the cost of living. If the people are spending more money to live, they have less money to satisfy their obligations (assuming their earnings haven't increased). With rising prices and no increase in wages, the people experience a decrease in purchasing power. As a result, the people may 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. Default is the failure to repay a debt, including interest or principal on a loan. When the cost of living rises, people may be forced to spend more of their wages on nondiscretionary spending, such as rent, mortgage, and utilities. This will leave less of their money for paying off debts, and borrowers may be more likely to default on their obligations.

Increasing Interest Rates

If inflation is rising against the backdrop of a growing economy, this may result in central banks, such as the Federal Reserve, increasing interest rates to slow the rate of inflation. Higher interest rates may lead to a slowdown in borrowing as consumers take out fewer loans. However, the rise in interest rates can help lenders earn more profits, particularly variable-rate credit products such as credit cards.