Question

When expected inflation is accurate: lenders will generally:

A. gain relative to borrowers. B. lose relative to borrowers. C. neither gain nor lose relative to borrowers. D. The effect will be totally random.

Answer 1

Consider the given problem here the “i=nominal interest rate” is the sum of “r=real interest rate” and the expected inflation, where “r” will be determined by the goods market equilibrium condition. So, mathematically we can write “i = r + pe , where “pe” be the expected inflation. Now when the inflation is known then the same condition look like.

=> ra = i – p, where “ra” be the actual real interest rate or inflation adjusted “r” and “p” be the actual inflation.

Now, if the “expected inflation” is less than the “actual inflation” that “pe < p”, => given the “nominal interest rate” the “actual real interest rate” is less than the goods market clearing “real interest rate” that is “ra < r”. So, here lenders are worse off as the as the “inflation adjusted r” is less than “r”.

Similarly, if the “expected inflation” is more than the “actual inflation” that “pe > p”, => given the “nominal interest rate” the “actual real interest rate” is more than the goods market clearing “real interest rate” that is “ra > r”. So, here lenders are better off as the as the “inflation adjusted r” is more than “r”.

Finally, if the “expected inflation” is equal to the “actual inflation” that “pe = p”, => given the “nominal interest rate” the “actual real interest rate” is equal to the goods market clearing “real interest rate” that is “ra = r”. So, here lenders are neither better off nor worse off as the as the “inflation adjusted r” is equal to “r”.

=> So, here the correct option is “C”.