“Borrower” and “Lender” are the options on both questions. Consider two scenario

Question

“Borrower” and “Lender” are the options on both questions. Consider two scenarios. In the first, the nominal interest rate is 6 percent and the expected rate of inflation is 4 percent. In the second, the nominal interest rate is 5 percent and the expected rate of inflation is 2 percent. In which situation would you rather be a lender? In which would you rather be a borrower? In the first scenario you would rather be a (Click to select) In the second scenario, you would rather be a [ (Click to select)

Explanation / Answer

First Scenario had a real Interest = (1.06) / (1.04) - 1 = 0.0192 or 1.92 %

Second scenario had a real Interest = (1.05) / (1.02) - 1 = 0.0294 or 2.94 %

Explanation

(1) Under inflation conditions real interest earned will be lower than the nominal interest. Such interest rate can be estimated using the formula ...... ( 1 + nominal rate ) / ( 1 + inflation rate ) - 1

(2) Lender wants to have higher real interest as it is his earning ......... Hence second scenario suits a lender position

(3) Borrower wants to have lower cost of funding. Hence he prefers a scenario with lower real interest rates.

In the first scenario you would rather be a Borrower In the second scenario you would rather be a Lender

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