Question

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 lower than they both expected.

1. Is the real interest rate on this loan higher or lower than expected?
2. Use your own “made-up” figures for nominal interest rate, expected inflation rate and actual inflation rate to explain your answer in part “a”?
3. Does the lender gain or lose from this unexpectedly low inflation? Does the borrower gain or lose?
4. Inflation since the Global Financial Crisis (GFC) has been much lower than people expected it to be. How has this affected home-owners who obtained fixed rate mortgages in the mid -2000s? How did it affect the banks that lent them the money?
5. If you were taking a mortgage today, how would your expectations about inflation in next 10 years affect your decision about whether to fix your mortgage or let it vary?

Answer 1

a) the real interest rate is given by the nominal interest rate - the rate of inflation. If inflation is lower than expected, then the real interest rate is higher then expected as will be seen in part (b)

b) Let's take the nominal interest rate to be 7%. If the expected inflation is 4%, then the expected real interest rate is = 7% - 4% = 3%.

Now if the actual inflation happens to be lower, say, 2%, the real interest rate will be = 7% - 2% = 5%, which is higher than the expected real interest rate of 4%

(c) The borrower loses from the unexpectedly low rate of inflation. It is because the real interest that he has to pay on his borrowings will increase which makes him worse off. The lender gains as the real interest rate he receives on his lending has increased which makes him better off.

(d) Homeowners who obtained fixed mortgage loans are paying a higher real interest rate than expected as inflation has turned out to be lower than expected post the recession. Thus, they are worse off. The banks on the other hands will see improved profitability as the real interest they receive is higher than expected.