3. (20 points) Maryam agrees to lend Zain $400,000 to buy computers for his cons

Question

3. (20 points) Maryam agrees to lend Zain $400,000 to buy computers for his consulting firm. They agree to a nominal interest rate of 6%. Both expect the inflation rate to be 2%. (a) Calculate the expected real interest rate. (b) If inflation turns out to be 3% over the life of the loan, what is the real interest rate? Who gains from unexpectedly high inflation, Maryam or Zain? (c) If inflation turns out to be 1% over the life of the loan, what is the real interest rate? Who gains from unexpectedly low inflation, Maryam or Zain?

Explanation / Answer

a) Expected real interest rate = Nominal interest rate - expected inflation rate = 6% - 2% = 4%

b) If the inflation rate turns out to be 3%, the real intesrest rate = 6% - 3% = 3%

Since the actual real intesrest rate is lower than the expected real interest rate, the interest to be paid by Zaid and recieved by Mariam is less than expected, so Zaid gains and Mariam loses.

c) If the inflation rate turns out be 1%, the real interest rate = 6% - 1% = 5%

Since the actual interest rate is higher than the expected interest rate, the interest to be paid by Zaid and recieved by Mariam is greater than expected, so Mariam gains and Zaid loses.

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