Question

If you borrow $20,000 to finance your college education at a fixed interest rate of 5%, explain in your own words the redistribution of income that occurs if the rate of inflation jumps to 8% by the time you begin repaying the loan, discussing any winners and any losers from increased rate of inflation.

Answer 1

An increase in the inflation rate causes the transfer of wealth from the lender to the borrower. For example, if $20,000 can buy 100 units of a certain item in the year when we took a loan then after accounting for inflation at the time we start repayment the purchasing power of the same $20,000 will be much lesser i.e. the inflation causes the real value of the money to fall.

It will make the borrower the winner because of the real value the money we are paying back is much lesser than the real value of money we borrowed. The lender is the looser because what the college is receiving back will purchase much less after the inflation.

Here, the actual loss will be of 3% because that will be the difference between the interest rates charged and inflation.