If expectations turn out to be correct, then the inflation compensation that was agreed upon at the beginning of the loan exactly makes up for the erosion in purchasing power during the life of the contract. If actual inflation turns out to be higher than expected, the inflation compensation turns out too small. Since the creditor is only partially compensated for the erosion of purchasing power, the debtor gains at his expense. On the other hand, if actual inflation turns out to be lower than expected, the inflation compensation more than offsets the erosion of purchasing power, and the lender gains at the expense of the borrower. Thus, unexpected inflation transfers wealth between creditors and debtors.
Debtors gain when inflation is unexpectedly high, and creditors gain when it is unexpectedly low.
Setting Monetary Policy by Majority Rule Now imagine what would happen if monetary policy were set by majority vote. Once loans are made, creditors would have a short-term incentive to vote for policies which would deliver an inflation rate that is lower than the one implicit in the debt contract, because this would redistribute wealth in their favor. Similarly, debtors would have a short-term incentive to vote for policies which would generate an inflation rate that is higher than the one implicit in the debt contract, because this would redistribute wealth in their favor. If monetary policy were set by majority vote, the more numerous faction would prevail. Direct evidence on this question is hard to come by, but two observations suggest that debtors may be more numerous.