Question

Question 2: Explain how inflation can redistribute income. Why does an unexpected rise in the inflation rate make workers and lenders worse off? Who is made better off? Why does correctly anticipated inflation does not have these distributional effects?

Answer 1

During the inflation the price level of goods increases it causes purchasing power of fixed amount decreases. The inflation also affect the borrower and lenders because borrowers repay lenders their debt in cheaper money value because real rate(Nominal rate - inflation) of interest reduces. So there is redistribution of income because some wages and salaries increase more rapidly than the price level while other wages and salaries increase more slowly than the price level.

The unexpected inflation rate make workers and lenders worse off, because the real wage of worker reduces due to unexpected rise in inflation, it decreases the purchasing power of work because price level rises. Lenders worse off because the real rate(nominal - Inflation) of interest reduces. So when there is inflation, the value of the money borrowers pay back is less, it means the purchasing power of money reduces. For example lender lend $100 to a borrower at the interest rate of 3%. It means lender get $103 after an year. But inflation rate during the same year is 5% it means the basket of goods which can be bought today a $100 not affordable at $103 after an year you will need $105 to buy that. Lender clearly loses out purchasing power.

The borrower is better off because borrower pay the same fixed amount of  money but due to inflation the value of money reduces. Hence borrower better off during the inflation

Correctly anticipated inflation does not have these distributional effects because all the wage rate, interest rate and purchasing power increases according to change in inflation rate. If we know that inflation rate is 5% than it means that the wage rate is also increase by 5% or more than that, The nominal interest rate fixed by the lender is also according to the inflation rate. Hence we can say that correctly anticipated inflation does not have distributional effets in the economy. Because in this situation nobody lose nobody gain and value of money not eroded more than anticipation.