Question

Suppose that a borrower and a lender agree on the nominal interest rate to be paid on a loan. Then inflation turns out to be lower than they both expected.

(1) True or False: The real interest rate on this loan is lower than expected.

The lender (2) gains/loses from this unexpected lower inflation, and the borrower (3) gains/loses under these circumstances.

Inflation during the 1970s was much higher than most people had expected when the decade began.

Homeowners who obtained fixed-rate mortgages during the 1960s (4) were harmed by/benefited from the unexpected higher inflation (with regard to their mortgages), and the banks that made the mortgage loans (5) were harmed/benfited?

Answer 1

Ans:

1) False

when the inflation is lower than expected, the real interest rate will be higher, since

real interest rate = Nominal interest rate - inflation.

2) Gains

In case of unexpected lower inflation the lender gains and the borrower loses.This is because real value of the loan increases due to lower inflation.

3) Loses

In case of unexpected lower inflation the lender gains and the borrower loses.This is because real value of the loan increases due to lower inflation.

4) Benefited

In case of higher inflation borrowers are benefited and lenders are harmed. This is because the money that the borrowers repay is now worth less than when they borrowed it.

5) Harmed

In case of higher inflation borrowers are benefited and lenders are harmed. This is because the money that the borrowers repay is now worth less than when they borrowed it.