Inflation is typically thought of negatively, since rising prices erode purchasing power. But the trade-off is that it also erodes the real value of debt, and that can bolster household real wealth.

Consumers who come to understand this dimension may change their outlook and their behavior, with broad economic implications, according to Goethe University Frankfurt postdoctoral scholar Philip Schnorpfeil, Chicago Booth’s Michael Weber, and Goethe University’s Andreas Hackethal.

They conducted a randomized controlled trial involving more than 3,000 customers of a German bank in July 2022, when inflation was at a 70-year high of 8.7 percent. The researchers first asked participants a series of questions about the economy, their assets, and estimated changes in their net wealth over the previous 12 months. They then split them into a control group, which received information only about the rate of inflation; a “savings-erosion” group that read about how inflation could hurt savers; and a “debt-erosion” group that learned how inflation benefits debtors.

Specifically, the researchers gave each group a realistic but hypothetical example, telling the savings-erosion group, for instance, that inflation would reduce the real value of savings totaling €50,000 a year earlier to €38,800 at the time of the experiment. They told the debt-erosion group that a €50,000 loan taken out a year earlier would currently have a real value of €38,800.

Then they asked participants about their expectations over the following 12 months for real-estate prices, unemployment, interest rates, and household income. They also surveyed the participants about their planned spending.

But what about debt?

As part of the setup for a randomized controlled trial, the researchers tested participants’ prior knowledge about the wealth effects of inflation. While most were aware that inflation hurts the real value of cash and fixed-income investments, only about a third believed that it helps borrowers of fixed-rate loans.   

The researchers find an “asymmetric awareness of the erosion channel” of inflation. Three-quarters of all participants knew that inflation would reduce the real value of savings, but only a third understood it would also lower the real value of fixed-interest-rate debt. The group that learned about inflation’s impact on savings subsequently was more bearish about savings than the control group. Those who received information about debt erosion were less credit averse.

Similarly, those in the savings-erosion group estimated a greater decline in their real net wealth than the control group, while members of the debt-erosion one guessed that their wealth increased by 2.5–2.9 percentage points. This is a dramatic swing from the control group’s estimate of a 5.6 percent drop in net wealth.

The researchers followed the participants for several weeks after the experiment. Those in the debt-erosion group increased their planned and actual spending. “Our results suggest that changes in real net wealth affect households’ consumption response to inflation, conditional on households being aware of the wealth effects of inflation,” they write.

Participants in the debt-erosion group also were more bullish than members of the control group about borrowing to buy real estate, and were more likely to choose fixed-rate rather than adjustable-rate mortgages, the research demonstrates.

“Our findings suggest that real wealth mediates the sensitivity of consumption to inflation once households are aware of the wealth effects of inflation,” the researchers write. “Our results document the redistributive nature of surprise inflation across households and provide causal estimates for how individuals adjust behavior following inflation-induced redistribution of wealth.”

The results may contribute to understanding how to optimize monetary policy, the researchers say. The findings also highlight a gap in otherwise well-informed consumers’ understanding of the effects of inflation.

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