Question

Assume you are borrowing money from a car dealer today to purchase a new car. It is expected that inflation will average 3% per year over the next five years – the life of the car loan. This inflation expectation has been built into the interest rate you are being charged on the five-year, fixed interest rate car loan – the rate, and therefore your monthly payment, cannot be changed. Based on the facts above, it will benefit the lender if the actual inflation rate over the next 5 years turns out to be lower than expected inflation rate at the time the loan was made. Indicate whether this statement is TRUE or FALSE; and explain why

Answer 1

The Statement is "true"

If it turns out that the real inflation is less than the expected inflation it will benefit the lender. For example, the interest rate charged is 7% and after taking inflation into account it was increased to 10% (interest + inflation). The lender took into account the inflation at 3% before making a decision.

Now if the real inflation is less than expected his return will increase. Say the real inflation rate is only 2%, according to that the lender should have charged just 9%. The lender has gained 1% more because of low inflation. The lower the inflation in the real market the more the lenders will gain. and higher the inflation the more the borrowers will gain.