7. Unanticipated changes in the rate of inflation Initially, Crystal earns a sal

Question

7. Unanticipated changes in the rate of inflation

Initially, Crystal earns a salary of $400 per year and Brian earns a salary of $200 per year. Crystal lends Brian $100 for one year at an annual interest rate of 20% with the expectation that the rate of inflation will be 16% during the one-year life of the loan. At the end of the year, Brian makes good on the loan by paying Crystal $120. Consider how the loan repayment affects Crystal and Brian under the following scenarios. Suppose all prices and salaries rise by 16% (as expected) over the course of the year. In the following table, find Crystal's and Brian's new salaries after the 16% increase, and then calculate the $120 payment as a percentage of their new salaries. Consider an unanticipated decrease in the rate of inflation. The rise in prices and salaries turns out to be 5% over the course of the year rather than 16%. In the following table, find Crystal's and Brian's new salaries after the 5% increase, and then calculate the $120 payment as a percentage of their new salaries.

Explanation / Answer

SCENARIO - 1

Crystal's new salary = $400 x 1.16 = $464

Payment as % of new salary = $120 / $464 = 0.2586 = 25.86%

Bryan's new salary = $200 x 1.16 = $232

Payment as % of new salary = $120 / $232 = 0.5172 = 51.72%

SCENARIO - 2

Crystal's new salary = $400 x 1.05 = $420

Payment as % of new salary = $120 / $420 = 0.2857 = 28.57%

Bryan's new salary = $200 x 1.05 = $210

Payment as % of new salary = $120 / $210 = 0.5714 = 57.14%

So,

Unanticipated decrease in inflation rate benefits Lenders and harms Borrowers.

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