Suppose we expect an inflation rate of 2% for the next year. If a lender require

Question

Suppose we expect an inflation rate of 2% for the next year. If a lender requires a 3% real return on a one year loan, what interest rate should he charge?

Refer to above. Suppose we get an unexpected 1% of additional inflation over the year. Who is made worse off by this? Who is made better off? What does this imply about inflation’s ability to arbitrarily redistribute wealth?

Refer to above. Given your answer in 10, how do you believe credit and financial markets will respond in the presence of uncertainty about inflation? If the Fed wants to keep these markets stable, how should it behave?

Explanation / Answer

inflation rate is 2% for a return of 3% the interest rates will be higher i.e. 5% because there is high inflation in the economy . With high inflation the borrower will be better off because he will still return at the old interest level but lenders are worse off . Inflation leads to speculations and arbitrage opportunities for the investors and borrowers in the market, ffed has to use a mix of both monetary and fiscal policy to keep the financial market stable .

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