Question

Era borrowed $20,000 from Struan Bank at the quoted interest rate of 10%. The bank hoped to generate 5% real return on the loan it extended to Era for 3 years. The actual average inflation over the 3 years of the life of the loan was 7%. Who’s better off in this situation, the borrower (Era) or the lender (Struan Bank)? Explain.

Answer 1

The nominal interest rate is 10%.

Bank hopes to generate real return of 5% on the loan.

So, the expected real interest rate is 5%.

Expected inflation rate = Nominal interest rate - Expected real interest rate = 10% - 5% = 5%

Thus, the expected inflation rate is 5%.

However, the actual inflation rate turns out to be 7%.

When actual inflation rate is greater than the expected inflation rate then borrower is better off while lender is worse off.

This is because when actual inflation rate is greater than the expected inflation rate then actual real interest rate turns out to be lower than the expected real interest rate.

This means borrower will pay less in real terms than expected while lender will receive ess in real terns than expected.

This will benefit borrower while adversely impact the lender.

Thus,

The borrower (Era) is better off in this situation.