Question

What happens when expected inflation is higher than actual inflation?.

Answer 1

When the expected inflation is higher tha actual inflation,your money holds onto more of its buying power. That's good. But if you're a borrower, a lower-than-expected inflation rate essentially costs you money.

When setting interest rates, lenders start with the expected rate of inflation and then add in what's known as the "real" interest rate - their actual return on the loan. For example, say you need to borrow $100 for a year. To make the deal worth its while, the lender needs to earn a 3 percent real return on its money. The lender expects the rate of inflation over the year to be 2.5 percent. So it sets the interest rate on the loan at 5.5 percent - 2.5 percent to take care of inflation, and 3 percent to get its required return. This "total" rate is referred to as the nominal rate.

When the actual rate of inflation is lower than the expected rate, borrowers wind up paying more than they "should" in interest. Continuing the example from before, say that the actual rate of inflation turns out to be 1.2 percent rather than 2.5 percent. You're still paying the 5.5 percent nominal interest rate on the loan, since that rate is specified in the loan agreement. But now the lender is enjoying a real return of 4.3 percent after inflation, rather than the mere 3 percent it was expecting. Good for the lender, bad for you.