Question

Answer the following:

1. A bank makes a loan at a 7.0% nominal interest rate to a business. For each of the following scenarios, calculated the expected and actual real interest rates on the loan and state whether the bank is better-off, worse-off, or just as well-off as it expected.

1. Inflation was expected to be 4%, but actual inflation was 2%

2. Inflation was expected to be 3%, but actual inflation was 3%

3. Inflation was expected to be 2% and actual inflation was 4%

Answer 1

First we understand relation between interest rate and inflation. Generally there is negative relation between interest rate and inflation. If interest rate is low more people able to borrow more money. More money in hands of consumer means higher spending causes economy to grow and inflation and vice versa.

In first condition banks are better off actual inflation is less than expected inflation. It means value of money depriciate less due to less inflation rate. So crediors( bank ) will be benefited and debtor loss.

Expected interest rate is 7-4= 3

Real interest rate 7-2 = 5

In second condition bank are well off because actual inflation equal to expected inflation rate. Means expected depricate in money value equal to actual depriciate in money.

Both expected and actual interest rate is 4%

In third condition banks are worse off because actual inflation more than expected inflation rate. It means actual depriciate in money value is more than expected.

Expected interest rate 5%

Actual interest rate is 3%.