Question

Boris Borrower and Lynn Lender agree that Lynn will lend Boris $10,000 and that Boris will repay the $10,000 with interest in one year. They agree to a nominal interest rate of 8%, reflecting a real interest rate of 3% on the loan and a commonly shared expected inflation rate of 5% over the next year.

If the inflation rate is actually 6% over the next year, how does that lower-than-expected inflation rate affect Boris and Lynn? Who is better off?

		Boris will be better off.
		Lynn will be better off.
		This will be better off for both of them.
		Both will be worse off.

Answer 1

Ans. Real interest rate = Nominal interest rate - Expected inflation rate

So, at decided nominal interest rate of 8% and expected inflation of 5%,

Real interest rate = 8 - 5 = 3%

But if inflation turns out to be 6%,

real interest rate = 8 - 6 = 2%

So, the interest income earned on the loan by Lynn falls and interest cost paid by Borris decreases. So, Lynn becomes worseoff and Borris becomes better off.

Although if the actual inflation rate would have been turned out to be less than 5%, then Lynn would have been better off while Borris worse off as the real interest rate would be more than 3%.
Thank you