Previous Year Question
Consider the following statements:
Inflation benefits the debtors.
Inflation benefits the bondholders.
Which of the statements given above is/are correct?
1 only
2 only
Both 1 and 2
Neither 1 nor 2
Correct Answer: A
Detailed Solution
Inflation reduces the purchasing power of money. Its effect consequently depends upon whether a person has to pay a fixed amount as a debtor or receive a fixed amount as a creditor or bondholder.
Statement 1 is correct
A debtor has borrowed money and must repay a specified nominal amount in the future.
If the loan carries a fixed interest rate and unexpected inflation increases:
The real value of the repayment declines.
Nominal incomes and prices may increase.
The Real Burden of Debt may fall.
The borrower repays the debt in money with lower purchasing power.
The relationship can be understood through the Fisher approximation:
Where:
r = Real Interest Rate
i = Nominal Interest Rate
π = Inflation Rate
If the Nominal Interest Rate on a loan is 8% and inflation increases from 3% to 7%, the approximate Real Interest Rate declines from:
8% - 3% = 5%
to:
8% - 7% = 1%
The real burden borne by the debtor consequently declines.
Therefore, unexpected inflation generally benefits fixed-rate debtors.
Statement 2 is incorrect
A bondholder lends money to the Government or a company and generally receives a fixed coupon and a fixed principal amount at maturity.
When inflation rises:
The purchasing power of the fixed coupon declines.
The real value of the principal received at maturity falls.
Interest rates on newly issued securities may increase.
The market price of an existing fixed-rate bond may decline.
For example, if a bond pays a fixed annual coupon of ₹8,000, that ₹8,000 purchases fewer goods and services after an 8% rise in the price level.
Thus, an ordinary fixed-rate bondholder loses rather than benefits from inflation.
Important qualifications
The effect may differ in special cases:
The principal or interest of an Inflation-indexed Bond may adjust with inflation.
The coupon on a Floating-rate Bond can change over time.
If expected inflation has already been incorporated into the Nominal Interest Rate, the debtor’s unexpected benefit may be smaller.
A debtor whose income does not rise with inflation may still face repayment difficulty.
However, for ordinary fixed-rate debt, the principle tested by UPSC is clear: inflation benefits the debtor and harms the creditor or bondholder.