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    Nominal and Real Interest Rates on a Loan

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    Suppose that a borrower and a lender agree on the nominal interest rate to be paid on a loan. Then inflation turns out to be higher than they both expected.

    a. Is the real interest rate on this loan higher or lower than expected?
    b. Does the lender gain or lose from this unexpectedly high inflation? Does the borrower gain or lose?
    c. Inflation during the 1970s was much higher than most people had expected when the decade began. How did it affect homeowners who obtained fixed- rate mortgages during the 1960s? How did it affect the banks that lent the money?

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    Solution Preview

    a. Is the real interest rate on this loan higher or lower than expected?

    Real interest rate and inflation rate have an inverse relationship. If the inflation increases, real interest rate goes down and if the inflation decreases, real interest rate goes up. Since the inflation turns out to be ...

    Solution Summary

    The expert examines nominal and real interest rates on a loan.

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