Question

a) Suppose the Happy land Bureau of Statistics indicated that the Consumer Price Index (CPI) increased 102.2 in 2017 to 105.5 in 2018. Use this information to answer the following questions: (i) Calculate Happy land’s inflation rate in 2018.

Suppose a firm borrowed money from a bank, examine the effect of inflation to the parties (firm and bank).

Answer 1

Inflation rate is nothing but the % change in cpi

=> (105.5 - 102.2)/102.2 × 100 = 3.23%

When a firm borrows from a bank, it has to repay the loan with interest. Because of inflation, the money supply in the economy is high and the firms won't have any problems repaying the loans in this scenario and therefore they are better off. Banks are at a loss because the purchasing power has increased but yet the banks don't make enough profits from these loans. The real interest rate or rate of return in the loan is much less in a bank's perspective during inflation. Therefore banks are worse off.

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