How inflation affects savers, lenders and borrowers

Effect: The real value of the money they hold falls. If you keep £100 in a savings account, after 2 % inflation it can buy only 98 % of what it could before.

• Interest earned may not keep up with inflation.
• Real return can become negative: $r_{\text{real}} = r - \pi$.
• Example: £1,000 at 3 % interest → £1,030, but 2 % inflation → real value £1,010.

Effect: The money they receive back is worth less in real terms. The lender’s purchasing power shrinks.

• Nominal interest must be higher to compensate for inflation.
• Real interest rate: $r_{\text{real}} = r_{\text{nominal}} - \pi$.
• Example: Lending £5,000 at 4 % when inflation is 3 % → real return 1 %.

Effect: Borrowers benefit because the money they repay is worth less.

• Real cost of debt falls: $r_{\text{real}} = r_{\text{nominal}} - \pi$.
• Example: Mortgage at 5 % with 2 % inflation → real cost 3 %.
• However, higher inflation can lead to higher nominal rates, offsetting the benefit.

Exam Tip 🚀

Remember: Use the formula for real interest to show the effect of inflation on each group. Highlight that savers lose purchasing power, lenders lose real returns, and borrowers gain (unless rates rise). Provide a clear example with numbers to demonstrate the calculation.