Winners and losers from inflation and deflation | AP Macroeconomics | Khan Academy

What we're going to do in this video is talk more about inflation and deflation, which we've talked about in other videos. But we're going to talk about it in the context of who benefits and who gets hurt, especially in a situation where people are lending money to each other at fixed rates.

So let's set up a little scenario here. Let's say that this is today, and this is in one year. So in one year, and today I need my teeth cleaned. It's an emergency, but I don't have money to clean my teeth. It costs a hundred dollars, and you're my okay friend. You say, "Yes, you do need your teeth cleaned. I will lend you a hundred dollars, but I want to charge some interest."

So today, from my point of view, I am going to borrow 100 from you, my okay friend. In a year, I have to pay back. You're gonna charge me 10 interest, so I'm going to have to pay back 110.

Now, let's think about some different scenarios on inflation. So let's imagine a world where there's no inflation. So let's say in, let's say today is my base period where the CPI is 100, and let's imagine that the actual basket of goods in our country is actually a hundred dollars. It'll help us visualize things a little bit more.

Let's say we have no inflation. So in one year, the CPI, that basket of goods, is still 100. So in real terms—and in future videos, we'll talk more about real and nominal terms—but in real terms, you could buy 10 more with 110 than you could with that hundred dollars. So you really got a real 10 return.

But now let's imagine a scenario with a little bit of inflation, a reasonable amount, where in our base year our CPI is 100. Then in a year, maybe we've had two percent inflation, so now our consumer price index is 102. Well, in this scenario, you're now—and especially if we view that basket of goods as actually costing a hundred dollars in the first year and then 102 one year later—as we've talked about, that's not always going to be the case. In fact, in most countries, it's not that you can actually buy that basket of goods for a hundred dollars. The hundred is usually just to be indicative, but this is to help us make things a little bit more tangible.

In this world, you're going to be able to buy more than a basket of goods, but not 10 more. You're going to be able to buy a little bit less than 8 percent more. Then we can set up a scenario where we have fairly extreme inflation, and this will make things very clear, where our CPI goes from 100 to, let's say, that price is more than double.

So let's say we go to a world where our CPI—so this would be pretty, pretty extreme inflation—where our CPI goes to 220. So this is really interesting because right now, at the present, what you are lending me, that's equivalent to the basket of goods. I could actually buy the basket of goods there, while in year one what I'm paying back to you, you can only buy half a basket of goods.

And so you lent me money, and even though nominally it looks just superficially like you're getting 10 more in terms of dollars, you can buy half as much with that 110 dollars as you could have bought a year ago with that hundred dollars. So in this world, even though it looks like you're getting a 10 nominal return, your real return is pretty bad. Your real return is negative 50. You can buy half as much with what you're getting paid back as what you originally lent.

So the general trend here is when you are in an inflationary environment, especially when the inflation is more than expected, oftentimes the interest rate will bake in some inflation. People will expect some inflation in the interest rate. But in general, inflation is going to—the more inflation you have—and think about it from my point of view. I borrowed something where I could have bought the basket of goods. If you imagine the basket of goods actually costs a hundred dollars, and I'm paying back something where that would only buy half a basket of goods, you could even imagine with that hundred dollars I buy a basket of goods, and then a year later I sell that basket of goods for 220.

Then I only have to pay half of that 220 back to you, and so I would have gotten my teeth cleaned in that situation, but I would have been able to profit from that thing. So inflation, especially when it's more than expected inflation, it benefits borrowers at fixed rates. I keep saying at fixed rates because it's possible that your interest rate might somehow be pegged to inflation, in which case it might not benefit you so much and it hurts lenders. It hurts lenders at fixed rates.

Now, as you can imagine, deflation is going to be the opposite. To make this very clear, I'll make a very extreme deflationary scenario. Imagine we go from a CPI of 100 to a CPI of 55, and if we literally view our—that same basket of goods that would have cost 100 only costs 55. Now think about it; I am borrowing equivalent of a basket of goods, and that I'm paying back to you two baskets of goods. 110 would buy two baskets of goods in a year.

So in this deflationary scenario, you are actually getting—even though nominally it looks like you're getting a 10 return—the lender is getting a 10 return. The real return they're getting is a hundred percent return. They're able to buy twice as much with what they get back than what they lent. So this deflation hurts borrowers at fixed rates, hurts borrowers at fixed rates, and it helps lenders, lenders at fixed rates.