Inflation and its Effects

Slides By

John Dawson and Kevin Brady

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Material from this presentation can be found in:

Chapter 16

CoreEconomics, 2e

Answer

QUESTION 1:

Suppose a close friend asks you to loan her $1,000 for one year and agrees to pay interest on the loan. So, you withdraw the $1,000 from your savings account and must now decide what interest rate to charge your friend for the loan.

A. After doing some research, you conclude that you could invest your money elsewhere and earn a real return of 3% during the next year. How does this information influence the nominal interest rate you charge your friend for the loan? Should you charge her an interest rate of 3%?

B. Suppose on the night before you agree to terms on the loan with your friend, you hear a reputable news report that inflation over the coming year will be 4%. How will this influence the nominal interest rate you quote your friend for the loan?

C. Suppose the actual inflation rate over the course of the loan turns out to be 5%. How does this affect you? Your friend?

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Inflation and its Effects

ANSWER:

A. If you require a 3% real return on the loan, you would want to charge your friend at least a 3% nominal interest rate on the loan. In addition, you would also need to account for inflation over the course of the loan. For example, if you expect inflation to run at 2% over the next year (expected inflation is what matters here because we don’t know the actual inflation rate in the future), you would need to charge 3% + 2% = 5% to realize the real return of 3% during a period of 2% inflation.

B. If you believe the forecast of 4% inflation over the coming year, you would need to charge your friend a nominal interest rate of 7% on the loan in order to realize the 3% real return you require. Note that the higher the expected rate of inflation, the higher is the nominal interest rate on the loan required to achieve an expected real rate of 3%.

C. If the actual inflation rate turns out to be 5% during the year and you charge your friend a nominal interest rate of 7%, you will realize a real return of only 2% (less than the 3% you wanted at the beginning of the loan). In other words, you as a lender are harmed by the higher-than-expected inflation while your friend, the debtor, benefits.

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Inflation and its Effects

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