Question

Suppose the fixed interest rate on a loan is​ 5.75% and the rate of inflation is expected to be​ 4.25%. The real interest rate is​ 1.5%.   Suppose now that instead of​ 4.25%, the inflation rate unexpectedly reaches​ 5.5%. Who gains and who loses from this unanticipated​ inflation?  
​(Mark all that​ apply.)
A. Lenders gain from a lower real interest rate.
B. Borrowers lose from a lower real interest rate.
C. Lenders lose from a lower real interest rate.
D. Borrowers gain from a lower real interest rate.

Answer 1

The answer is (d)

If the inflation is higehr than the expected inflation rate, the borrowers will gain as they now have to pay a lower interest rate and the lenders will lose as they receive a lower interest rate.

Real interest rate expected = 5.75 - 4.25 = 1.5

Real interest rate after unexpected inflation = 5.75 - 5.5 = 0.25 < 1.5

Thus, the answer is (d)