1. more / less 2. higher / lower Thanks. Suppose two parties agree that the expe
ID: 1222788 • Letter: 1
Question
1. more / less
2. higher / lower
Thanks.
Suppose two parties agree that the expected inflation rate for the next year is 3 percent. Based on this, they enter into a loan agreement where the nominal interest rate to be charged is 7 percent. If inflation for the year turns out to be 2 percent, who gains and who loses? Instructions: Enter your responses as whole numbers The ex ante real interest rate is percent. This is what borrowers think they are paying and lenders think they are earning. With the actual inflation of 2 percent, the ex post real interest rate will be percent. This benefits the lender because the lender is earning in real terms than he or she anticipated. The borrower loses when inflation is lower than expected, as the borrower is paying a real interest rate than he or she anticipated.Explanation / Answer
The relation between the real, nominal and inflation rate is given as,
(1 + real interest rate, r) * (1 + inflation, i) = (1 + nominal interest rate, R).
Ex ante real interest rate = (1 + r) * (1 + 0.03) = (1 + 0.07).
Ex ante real interest = (1 + r) * (1.03) = 1.07
Ex ante real interest = (1 + r) = 1.0388
Ex ante real interest = r = 1.0388 - 1
Ex ante real interest r = 0.388
r% = 3.88%.
2. Ex post, (1 + r) * (1 + 0.02) = (1 + 0.07)
(1 + r) * 1.02 = 1.07
(1 + r) = 1.049
r = 1.049 - 1
r = 0.049
r% = 4.90%
3. More.
Inflation distorts the value of money or lowers the purchasing power of the consumer. Anticipated inflation is less than the actual inflation which reduces the value by a lesser amount.
4. Higher.
Borrower would have to pay more when the inflation is lower because the purchasing power is not distorted.
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