Why are borrowers harmed by unanticipated deflation

Arbitrary redistribution of wealth from borrowers to lenders. Given that the experience of many countries in the recent past has been that of steadily rising prices, many long-term contracts are written with the expectation of continuing inflation. Thus, when unanticipated deflation occurs, these contracts need to be adjusted. It is reasonable to expect that these adjustments will not be instantaneous, since many contracts cover an extended period of time.

Without adjustments, unexpected deflation will lead to arbitrary redistribution of wealth from borrowers to lenders the opposite of the case of unanticipated inflation. Steady-State Costs of Deflation Menu costs. Whether prices need to be revised up as in case of inflation or down in case of deflation , there are costs to changing prices. Those costs include changing price tags, updating computer systems, reprinting catalogs, etc.

Loss of government revenue. Since tax provisions are based on nominal incomes, deflation may lead to a reduction in tax rates even in case of no change to spending power Fuhrer and Tootel Costs to monetary policy. The tool of many central banks including the Fed is short-term interest rates the fed funds rate in the case of U. Recall that periods of deflation are also periods of weak economy. When we think about the link between interest rates and output, we want to think about the real interest rate , the difference between the nominal interest rate and inflation.

When inflation is positive, it is possible for the central bank to push real interest rates down even below zero and stimulate investment spending and, perhaps, spending on durable goods. That, in turn, should boost overall output. However, nominal interest rates cannot fall below zero. Therefore, as the Japanese experience showed, in a situation with deflation and a recession, the central bank may not be able to push real interest rates low enough to alleviate the situation.

References Bank of Japan. 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.

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 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. 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.

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. Federal Reserve. International Markets. Deflation expectations make consumers wait for future lower prices. That reduces demand and slows growth. Deflation is worse than inflation because interest rates can only be lowered to zero.

Why does the Federal Reserve aim for inflation of 2 percent over the longer run? If inflation expectations fall, interest rates would decline too. In turn, there would be less room to cut interest rates to boost employment during an economic downturn. Inflation raises prices, lowering your purchasing power. It also lowers the values of pensions, savings, and Treasury notes.

Assets such as real estate and collectibles usually keep up with inflation. Variable interest rates on loans increase during inflation.

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