Given the following 4 scenarios: • The contract interest rate was 3.5% and the e

Question

Given the following 4 scenarios:

• The contract interest rate was 3.5% and the expected inflation rate was 1.5%.

• The contract interest rate was 5% and the expected inflation rate was 2%.

• The contract interest rate was 7.5% and the expected inflation rate was 4%.

• The contract interest rate was 9% and the expected inflation rate was 5%.

Ex post actual inflation rate is 4%.

a) Indicate which scenario would have been best for the lender and explain why it is best for the lender.

b) Indicate which scenario would have been best for society and explain why it is best for society.

Explanation / Answer

Ans. a) Scenario 1st is the best for lender because in this scenario the difference between the contract interest rate and expected inflation rate is minimum so that there will not be large variance between the two which is good for lender.

b)  Scenario 1st is the best for society as a whole because in this scenario also the difference between the contract interest rate and expected inflation rate is minimum which is best for both the lenders and borrowers of the society and also the effective interest rate will be nearby constant.

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