Effects of inflation and deflation

Effects of inflation

• Consumers: real incomes fall if wages and benefits rise more slowly than prices; savers lose if interest rates are below inflation; menu and shoe-leather costs.
• Workers: may push for higher wages, risking a wage-price spiral.
• Firms: uncertainty makes planning and investment harder; menu costs of changing prices.
• Government: tax revenue rises (and fiscal drag pulls people into higher bands if thresholds are frozen); the real value of government debt falls; it pays more for index-linked benefits.
• Income distribution: borrowers gain and savers lose; people on fixed incomes lose; those with assets that rise in value gain.
• Competitiveness and the current account: if inflation is higher than in trading partners, exports become less price competitive and imports more attractive, worsening the current account.

Real interest rates

Real interest rate ≈ nominal interest rate - inflation. If the nominal rate is 5% and inflation is 8%, the real rate is about -3%: savers lose purchasing power and borrowers gain.

Effects of deflation

• Consumers may delay purchases expecting lower prices, reducing AD further (a deflationary spiral).
• The real value of debt rises, hurting indebted households, firms and governments.
• Firms face falling revenue and profits, so cut wages, jobs and investment.
• Workers: real wages may rise, but nominal wages are hard to cut, so unemployment rises.
• Monetary policy is weaker because nominal interest rates cannot easily go below zero, so real rates stay high.
• Competitiveness: prices falling faster than abroad can improve export competitiveness.

Benign deflation caused by rising productivity is far less harmful than deflation from falling AD.

Worked example

A saver holds $10,000 at 5% interest for a year while inflation is 8%. Find the approximate change in the real value of the savings.

1. Nominal value after a year = 10000 x 1.05 = $10,500
2. Real value in last year's prices = 10500 / 1.08 = $9,722.22
3. Change = -$277.78

Answer: The real value falls by about $278 (a real interest rate of about -3%).

Check yourself

1. The nominal interest rate is 3% and inflation is 7%. Find the approximate real interest rate in %.
   Show answer

   -4 %. Real ≈ nominal - inflation = 3 - 7 = -4%.

2. Nominal wages rise by 4% and prices by 6%. Find the exact % change in real wages, to 2 decimal places.
   Show answer

   -1.89 %. Real wage index = 1.04 / 1.06 = 0.9811, a change of -1.89%.

3. Who is most likely to gain from unexpectedly high inflation?
   • A household with a large fixed-rate mortgage
   • A pensioner on a fixed money income
   • A saver with cash in a low-interest account
   • A bank that lent at a fixed rate
   Show answer

   A household with a large fixed-rate mortgage. The real value of the debt falls, so borrowers gain.

4. Inflation in Country A is 8% while its trading partners have 2%. With an unchanged exchange rate, the most likely effect is
   • an improving current account
   • lower imports
   • lower prices of A's exports abroad
   • a worsening current account as exports become less price competitive
   Show answer

   a worsening current account as exports become less price competitive. A's goods become relatively dearer, so exports fall and imports rise.

5. Why might deflation caused by falling AD reduce consumption further?
   • Real incomes of all workers fall
   • Consumers delay purchases expecting prices to fall more
   • Interest rates automatically rise
   • Exports become more expensive
   Show answer

   Consumers delay purchases expecting prices to fall more. Postponing spending reduces AD again, which can create a deflationary spiral.

6. How does deflation affect the real burden of a firm's existing debts?
   • It reduces it
   • It leaves it unchanged
   • It removes it
   • It increases it
   Show answer

   It increases it. Prices and revenues fall, but the money owed does not, so the real burden rises.

7. Why can high and volatile inflation reduce investment?
   • It always raises the exchange rate
   • Uncertainty about future costs and prices makes expected returns hard to predict
   • It reduces the money supply
   • It lowers business costs
   Show answer

   Uncertainty about future costs and prices makes expected returns hard to predict. Firms are reluctant to commit to long-term projects when they cannot forecast costs and prices.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification, Issue 2 (June 2018)
• Bank of England: Monetary Policy Summary, February 2024

Last updated 8 November 2026. Spotted a mistake? Tell us.