Chapter 14, Problem 2FRQ

a)

To determine

The question requires us to determine the real interest rate.

Consumers

Explanation of Solution

Given,

Borrowing amount = $1,000

Borrowing rate (nominal interest rate) = 5%

Unexpected inflation rate = 5%.

The following expression represents the relationship between inflation, the real rate of interest, and the nominal rate of interest.

  $\text{Nominal rate of interest = Real rate of interest + Inflation rate}$

Insert the given values,

  $\begin{array}{c}\text{Nominal rate of interest = Real rate of interest + Inflation rate}\\ \text{Real rate of interest = Nominal rate of interest - Inflation rate}\\ \text{Real rate of interest = }5\%-5\%\\ =0\%\end{array}$

The real interest rate on a loan is zero percent.

b)

To determine

The question requires us to explain the benefits of inflation.

Explanation of Solution

Consumers borrowed $1,000 to buy a couch at a 5% nominal interest rate for one year. After one year when inflation rises by 5%, the real value of $1,000 falls and thus, benefits the consumer as he pays zero real interest rate on his loan.

So, consumer gains from unexpected inflation.

Economics Concept Introduction

Inflation indicates an increase in the general prices of goods and services in a market. Lenders, savers, and individuals with fixed incomes are hurt by the inflation while borrowers gain from the inflation.

c)

To determine

The question requires us to determine the person who loses in the given situation.

Explanation of Solution

Consumers borrowed $1,000 to buy a couch at a 5% nominal interest rate for one year. After one year when inflation rises by 5%, the real value of $1,000 received by lenders will fall and thus hurts the lender as he gets zero return on his money. The lender would get a 5% return if inflation didn’t change, but now he gets zero return as the cost of unexpected inflation equals the nominal return on the loan.

So, the lender loses from unexpected inflation in the market.

Economics Concept Introduction

Inflation indicates an increase in the general prices of goods and services in a market. Lenders, savers, and individuals with fixed incomes are hurt by the inflation while borrowers gain from the inflation.