Question

Assume that the real rate of interest is 5 percent and a lender charges a nominal interest rate of 15 percent. If a borrower expects that the rate of inflation next year will be 10 percent and the actual rate of inflation next year is 12 percent:
a. neither the borrower nor the lender benefits from inflation.
b. both the borrower and the lender lose from inflation.
c. the borrower benefits from inflation, while the lender loses from inflation.
d. the lender benefits from inflation, while the borrower loses from inflation.

Answer 1

Answer:

Correct option is (c)

Explanation:

Nominal interest rate is the sum of real interest rate and inflation. The lender charged nominal interest rate of 15% expecting inflation to be 10% in the following year. However, inflation was 12%. So, nominal rate becomes 17% (12% + 5%).

The lender should have charged a nominal interest rate of 17% instead of 15%. Now, he has to bear the loss of 2%. Borrower on the other hand benefited as he is paying lower interest rate than what is prevailing in the market.