12.4: Effects of Inflation 1. Decreasing value of the dollar The dollar can buy less and less products as prices rise Hurts people on a fixed income (retirees) ↓ 2. Decreasing real return on investments Real return – not the dollars that are returned from investments, but the value of the dollars that are returned

Effects of High Inflation on Investment Assume: Inflation rate = 10% Interest rate = 5% $100 invested on Jan 1. and returned on Dec. 31 Date Transaction Value of Investor’s Borrower’s Transaction Real Return Real Return

Inflation rate = interest rate Inflation rate < interest rate Investors make 0 real return Inflation rate < interest rate Investors + real return Borrowers − real return Inflation rate > interest rate Investors − real return Borrowers + real return

3. Increasing interest rates Investors/lenders/creditors will charge higher interest rates during high inflation to make up for their declining real return This will in turn hurt borrowers

Summary Anyone on a fixed income (retirees, investors) are hurt by inflation Anyone with fixed expenses (borrowers) is helped by inflation Anyone with fixed income (lenders, retired) is hurt by inflation Eventually, interest rates will rise to compensate for this