Does Inflation Favor Lenders or Borrowers?

Inflation can benefit either lenders or borrowers, depending on the circumstances.

Inflation occurs when there is a general increase in the price of goods and services and a fall in purchasing power. This can benefit borrowers in that it allows them to repay debts with money that has depreciated in worth. However, it can also benefit lenders in that it raises prices and increases demand for credit.

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.

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. It can be represented by the following formula: MV=PQ, where M is the 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 velocity of money is assumed to be relatively constant, then 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.

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.

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, increasing 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.

How Inflation Helps Borrowers

If wages increase with inflation, and if the borrower already owed money before the inflation occurred, inflation benefits the borrower. This is because the borrower still owes the same amount of money, but now they have 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 worth less than it was when they originally borrowed it.

How Inflation Helps Lenders

Inflation can help lenders in several ways, especially when 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.

However, it’s important to note that the potential additional profit may be canceled due to the same factor: inflation. In other words, lenders may be hurt by inflation because they are paid back in money that has less purchasing power than the money they initially loaned out.   

Inflation and Cost of Living

If prices increase, so does the cost of living. If people spend 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, 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 more extended 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.

The Bottom Line

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.