02 Qustion (4 points) Harry expect an inflation rate of 7%. 1st attempt, Part 1

Question

02 Qustion (4 points) Harry expect an inflation rate of 7%. 1st attempt, Part 1 (1 point) Q See Hint The expected real interest rate on the loan is Part 2 (1 point) Q See Hint Suppose that when Sally pays back the loan after one year, the actual inflation rate turns outto be 6%. The actual real interest rate on the loan is See Hint Part 3 (2 points) a. If the inflation rate turned out to be higher than expected, then b. But if inflation turned out to be lower than expected, then oft, and Harry oft Sally is worse off, and Harry

Explanation / Answer

1. Real interest rate= Nominal interest rate - expected or actual inflation rate.

Therefore, Real interest rate= (9-7) = 2

2. Actual real interest rate= (9 - 6) = 3 and this is higher than contracted real interest rate.

3.

A. If the inflation rate is higher than expected, then the actual real interest rate is lower than contracted real interest rate. The lender looses and the borrower gains. So, in this case Sally is better off and Harry is worse off.

B. But if inflation turns out to be lower than expected then actual real interest rate is higher than contracted real interest rate. In this case, borrowers looses and lenders gains. So, Sally is worse off and Harry is better off.

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