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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?

    © BrainMass Inc. brainmass.com December 24, 2021, 10:45 pm ad1c9bdddf
    https://brainmass.com/economics/inflation/nominal-real-interest-rates-loan-505392

    SOLUTION This solution is FREE courtesy of BrainMass!

    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 higher than expected, real interest rate should be lower than expected.

    b. Does the lender gain or lose from this unexpectedly high inflation? Does the borrower gain or lose?

    Since real interest rate has decreased, the lender looses as he will be getting less interest in the real terms. Borrower will gain because of higher inflation as he is paying less in the real terms.

    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?

    Since inflation is higher than expected, real interest rate will be lower in 1970s. Homeowners who obtained fixed- rate mortgages during the 1960s, will be benefited as they will be paying less interest in real terms. Banks will be at loss as they will get less interest in the real terms.

    This content was COPIED from BrainMass.com - View the original, and get the already-completed solution here!

    © BrainMass Inc. brainmass.com December 24, 2021, 10:45 pm ad1c9bdddf>
    https://brainmass.com/economics/inflation/nominal-real-interest-rates-loan-505392

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