Suppose that a borrower and a lender agree on the nominal intrest rate to be pai

Question

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

a) Is the real interest rate on this loan higher or lower than expected

b) Dose the lender gain or lose from this unexpectedly high inflation? Does the borrower gain or lose?

c) Inflation during the 1970s was much higher than most people had expected when the decade began. How did this affect home-owners who obtained fixed-rate mortgages during the 1960's? How did it affect the banks that lent the money?

Explanation / Answer

a) Lower
b) Lender loses, borrower gains.
c) Home-owners gained, and saved money. Bankers lost money.

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