As we’ve just learned, a high inflation rate imposes overall costs on the economy. In addition, inflation can produce winners and losers within the economy. The main reason inflation sometimes helps some people while hurting others is that economic transactions often involve contracts that extend over a period of time, such as loans, and these contracts are normally specified in nominal—that is, in dollar—terms.

In the case of a loan, the borrower receives a certain amount of funds at the beginning, and the loan contract specifies the interest rate on the loan and when it must be paid off. The interest rate is the return a lender receives for allowing borrowers the use of their savings for one year, calculated as a percentage of the amount borrowed.

But what that dollar is worth in real terms—that is, in terms of purchasing power—depends greatly on the rate of inflation over the intervening years of the loan. Economists summarize the effect of inflation on borrowers and lenders by distinguishing between the nominal interest rate and the real interest rate. The nominal interest rate is the interest rate in dollar terms—for example, the interest rate on a student loan. The real interest rate is the nominal interest rate minus the rate of inflation. For example, if a loan carries an interest rate of 8%, but there is 5% inflation, the real interest rate is 8% − 5% = 3%.

When a borrower and a lender enter into a loan contract, the contract is normally written in dollar terms—that is, the interest rate it specifies is a nominal interest rate. (And in later chapters, when we say the interest rate we will mean the nominal interest rate unless noted otherwise.) But each party to a loan contract has an expectation about the future rate of inflation and therefore an expectation about the real interest rate on the loan. If the actual inflation rate is higher than expected, borrowers gain at the expense of lenders: borrowers will repay their loans with funds that have a lower real value than had been expected. Conversely, if the inflation rate is lower than expected, lenders will gain at the expense of borrowers: borrowers must repay their loans with funds that have a higher real value than had been expected.

Historically, the fact that inflation creates winners and losers has sometimes been a major source of political controversy. In 1896 William Jennings Bryan electrified the Democratic presidential convention with a speech in which he declared, “You shall not crucify mankind on a cross of gold.” What he was actually demanding was an inflationary policy. At the time, the U.S. dollar had a fixed value in terms of gold. Bryan wanted to abandon that gold standard and have the U.S. government print more money, which would have raised the level of prices. The reason he wanted inflation was to help farmers, many of whom were deeply in debt.

In modern America, home mortgages are the most important source of gains and losses from inflation. Americans who took out mortgages in the early 1970s quickly found their real payments reduced by higher-than-expected inflation: by 1983, the purchasing power of a dollar was only 45% of what it had been in 1973. Those who took out mortgages in the early 1990s were not so lucky, because the inflation rate fell to lower-than-expected levels in the following years: in 2003 the purchasing power of a dollar was 78% of what it had been in 1993.

Because gains for some and losses for others result from inflation that is either higher or lower than expected, yet another problem arises: uncertainty about the future inflation rate discourages people from entering into any form of long-term contract. This is an additional cost of high inflation, because high rates of inflation are usually unpredictable. In countries with high and uncertain inflation, long-term loans are rare, which makes it difficult in many cases to make long-term investments.

One last point: unexpected deflation—a surprise fall in the price level—creates winners and losers, too. Between 1929 and 1933, as the U.S. economy plunged into the Great Depression, the consumer price index fell by 35%. This meant that debtors, including many farmers and homeowners, saw a sharp rise in the real value of their debts, which led to widespread bankruptcy and helped create a banking crisis, as lenders found their customers unable to pay back their loans. And as you can see in Figure 8-12, deflation occurred again in 2009, when the inflation rate fell to −2% at the trough of a deep recession. Like the Great Depression (but to a much lesser extent), the unexpected deflation of 2009 imposed heavy costs on debtors. We will discuss the effects of deflation in more detail in Chapter 16.