Question

3. Given the following 5 scenarios for some hypothetical country: • A contract interest rate of 6.5% and an expected inflation rate of 3.5%. • A contract interest rate of 15% and an expected inflation rate of 13.5%. • A contract interest rate of 7.5% and an expected inflation rate of 4%. • A contract interest rate of 9% and an expected inflation rate of 5%. • A contract interest rate of 3.5% and an expected inflation rate of 1%.

a) Indicate which scenario would be best for the borrower and explain why it is best for the borrower.

b) With an ex post actual inflation rate of 4.3%, indicate which scenario would have been best for society and explain why it is best for society of the five options.

c) Explain an outcome that would have been better for society than what is offered by the scenarios above.

Answer 1

C) From the above scenarios scenario 4th is a better option for the society.

the difference between nominal interest rate i.e. a contract interest rate and inflation rate is real interest rate. for the growth of the economy the real interest rates should be more. if you must have noticed the interest rate of all the growing as in developing economies is always higher.

there are two aspects from the point of view of borrower and from the point of view of lender.

From the lenders point of view real interest should be more i.e. the difference between contractual interest rate and inflation rate should be more so in future the value will be more of the debt given. so in this case 4th scenario will be the best as the difference is 4%.

From the borrowers point of view real interest should be less i.e. the difference between contractual interest rate and inflation rate should be less so in future the value will be less of the debt taken. so for this case 2nd and 5th scenario is the best as the difference is 2.5%