14. You are in negotiations with a lender for a 1-year loan. The lender wants a

Question

14. You are in negotiations with a lender for a 1-year loan. The lender wants a 3 percent increase in the buying power of the money you return to them one year from now and everyone believes that inflation will be 2 percent over this time period.
A. Given the above, determine the nominal interest rate the bank will charge you. What is the bank’s anticipated real interest rate?

B. Assume inflation during this time period is higher than anticipated, specifically 6 percent. Who benefited from inflation being higher than anticipated? Who was hurt? Explain.

Explanation / Answer

Nominal interest rate = Real interest rate + inflation rate

A) Nominal interest rate charged by the bank = 3% + 2% = 5%

(Real interest rate = increase in the buying power (rate))

Anticipated real interest rate = 5% - 2% = 3%

B)

Inflation = 6%

Real interest rate earned by the bank = 5% - 6% = -1%

Since, the real interest rate earned is negative, bank (lender) would be hurt under such conditions. (buying power decreases)

Borrower would borrow at a favourable real interest rate and would therefore benefit from this situation.

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