Impacts of inflation on firms, savers, borrowers, trade and the government

Savers and borrowers

Savers lose.

• The real interest rate is the nominal rate minus inflation. When inflation exceeds the interest rate, the real return is negative.
• Savings grow in dollars but buy less than before.
• High inflation therefore discourages saving, which over time reduces the pool of funds available for investment.

Borrowers gain.

• Debts are fixed in nominal dollars. Inflation reduces the real value of the amount owed.
• If nominal incomes rise with inflation, a fixed repayment takes a smaller share of income each year.
• The gain and the loss are the same transaction: inflation transfers real purchasing power from lenders to borrowers.

The exception to note: if the RBNZ responds to inflation by raising the OCR, borrowers on floating rates face higher repayments, which can outweigh the erosion of the real debt.

Firms

Business costs

• Inflation raises the cost of wages, materials, energy and freight, squeezing profit margins unless firms can pass the costs on.
• Firms that cannot raise prices — because they face strong competition, or because their customers are price-sensitive — absorb the squeeze themselves.

Business confidence and investment

• Unpredictable inflation is worse for firms than high but stable inflation.
• Firms plan investment years ahead. If they cannot forecast costs and revenues, they delay or cancel investment, which reduces $I$ in aggregate demand and reduces the economy's future productive capacity.

Menu costs and administrative burden

• Menu costs are the real resource cost of repricing — updating price lists, labels, websites and contracts. Under high inflation this must be done constantly.

Stock and cash

• Firms holding large cash balances lose real value; firms holding stock may find its value rises.

Exporters and importers

Exporters lose competitiveness

• If New Zealand's inflation rate is higher than that of its trading partners, New Zealand costs and prices rise faster than theirs.
• New Zealand exports become relatively more expensive on world markets, so overseas buyers switch to cheaper suppliers and export volumes fall.
• This reduces $X$, which reduces AD, and worsens the balance on goods and services.

Importers and import-competing firms

• Importers may gain in the short term: if overseas prices are rising more slowly, imported goods look relatively cheap compared with domestically produced alternatives, so import volumes rise.
• Firms competing with imports therefore lose — domestic buyers switch to the cheaper imported option.
• Rising imports reduce $(X - M)$, worsening the current account balance.

The government

• The government's position is mixed, and the exam has asked directly about revenue, expenditure and the operating balance.

Revenue rises

• GST is charged as a percentage of price, so revenue rises automatically as prices rise.
• Income tax revenue rises as nominal wages rise. Because New Zealand's income tax brackets are set in dollars and not automatically indexed, workers receiving nominal pay rises move into higher tax brackets even if their real income has not increased — this is fiscal drag (or bracket creep), and it raises the average tax rate paid.

Expenditure also rises

• The government buys goods and services, employs a large workforce and pays indexed benefits and superannuation. All of these cost more as prices rise.
• Debt servicing costs can rise if interest rates rise in response to inflation.

The operating balance

• The operating balance is revenue minus expenditure.
• Whether inflation improves or worsens it depends on which rises faster. Revenue tends to respond immediately (GST is collected at the moment of sale; PAYE adjusts with each pay run), while much expenditure is indexed with a lag — benefits and pay settlements are adjusted annually, after the fact.
• So in the short run, inflation usually improves the operating balance, and the advantage narrows once expenditure catches up.