Question

Suppose the underlying real interest rate is 4%. People expect an inflation rate of 2.3% over the next year.

a) At what rate will banks set their interest rates?

b) Suppose inflation turns out to be 3%. Using your answer from (a), what does the real interest rate turn out to be?

c) Explain why unexpectedly high inflation helps borrowers

Answer 1

A.

Bank will set the nominal interest rate.

Nominal interest rate = Real interest rate + inflation rate

Nominal interest rate = 4%+2.3% = 6.3%

B.

If inflation rate = 3%

Then,

Real interest rate = 6.3% - 3%

Real interest rate = 3.3%

C.

With unexpected high inflation rate, borrowers will pay the same amount, but with less real value of money. As a result, borrowers will pay relatively less real value of money to the lenders. So, borrowers will become better off due to the higher unexpected inflation.