Suppose that in 2014 Julie lends Bill $1,000 to be repaid in 2015 at a nominal i

Question

Suppose that in 2014 Julie lends Bill $1,000 to be repaid in 2015 at a nominal interest rate of 5%. Additionally, suppose Julie and Bill both expect prices to rise by 2% between 2014 and 2015.

a. How much money will Bill repay Julie in one year, in 2015 dollars?

b. What is the ex ante real interest rate?

c. How much money does Bill expect to repay Julie in one year, in 2014 dollars?

d. Suppose prices actually rise 4% between 2014 and 2015. What is the ex post real interest rate? How much does Bill actually repay Julie in terms of 2014 dollars?

e. Who benefits from higher-than-anticipated inflation? Who is hurt by higher-thananticipated inflation? How can you tell?

f. Repeat part d), but suppose that prices actually rise 1% between 2014 and 2015.

g. Who benefits from lower-than-anticipated inflation? Who is hurt by lower-thananticipated inflation? How can you tell?

Explanation / Answer

Answer:

Julie has lent $1000 in 2014 at an interest rate of 5% therefore 1 year interest calculation would be $1000*5%= $50

a) Since both of them were mere expecting that the interest rate would go up by 2% but still the Bill would repay $1050 at the end of 2015.

b) Ex ante real interest rate = Nominal interest rate - Inflation rate

Therefore as per the given problem the ex ante real interest rate would be = 5%-2%=3%

c) Bill would expect to pay Julie at 7% interest rate i.e $1070

d) Ex post real interest rate = Nominal rate - Actual inflation rate

Therefore Bill would repay Julie = 5%-4%= @1% interest which would be $10 interest . Hence he would repay $1010

e) Bill is benefited from higher than anticipated inflation and Julie is affected because Julie lose out on interest because Bill has to reduce the interest amount due to increase in inflation rate.

f) If the prices actually rises by 1% then the ex post real interest rate would be = 5%-1%= 4% therefore Bill would repay Julie an amount of $1040.

g) e) Julie is benefited from Lower than anticipated inflation and Bill is affected because Bill has to pay more interest amount.

Thank You

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