Inflation is a general rise in prices. A certain amount of inflation occurs because of natural population growth and the increasing scarcity of some commodities. However, when inflation is high, the effect is to cause the value of money to rapidly declines. For example, in 2014 it takes $2.27 to buy what $1 bought in 1984. The erosion of buying power affects borrowers and lenders differently.
When a corporation or government issues bonds, it collects cash that it must pay back as interest and as a return of the debt’s face value. An individual undertakes debt through a mortgage, car loan, or credit card, also subject to interest and repayment of principle. When inflation causes the dollar’s value to erode, borrowers benefit by paying interest and principle using “cheaper” money. For example, a $1,000 30-year bond maturing in 2014 requires repayment of only ($1,000 / $2.27), or $440.53 in 1984 dollars.
Effect on Interest Rates
Lenders charge interest to reflect the time value of money. They weigh the benefits they could receive today by spending money versus the future benefits it will receive by lending the money. As inflation rises, lenders demand higher interest rates to protect against the currency devaluation that inflation causes. As interest rates rise, some potential borrowers will no longer be able to afford interest payments. Eventually, high inflation chokes off credit and slows economic growth. This might lead to a recession, stagnation or a depression.
Hardship for Lenders
While borrowers might appreciate paying off debt with cheaper money, lenders can face hardships when inflation is high. The money they collect in interest and principal payments has less value and therefore imposes a financial cost that can drain wealth from the issuer. For example, suppose a company planned to use the funds it receives when a bond investment matures to finance a project. During inflationary times, the face value it receives may not be enough to pay for the project, which probably costs more because of inflation.
As inflation undercuts buying power, consumers may increase their debt to maintain their lifestyles. Often, salaries do not increase sufficiently to avoid a growing gap between consumer income and expenses. Over time, some consumers will be unable to afford rising interest payments, such as those charged by credit card companies. Negative outcomes include a decline in personal wealth, defaults, and personal bankruptcies. These effects create a growing drag on the economy that can eventually replace inflation with recession or worse. Some investors buy gold as a hedge against inflation.