Question

In: Economics

Inflation rate during the 1970s was much higher than most people had expected when the decade...

Inflation rate during the 1970s was much higher than most people had expected when the decade began. Use the concept of real interest rate and explain:


a) How did this unexpectedly high inflation affect homeowners who obtained fixed-rate mortgages during the 1960s?

b) How did it affect the banks that lend the money during the 1960s?

Solutions

Expert Solution

a)  The fixed rate mortgage obtained by homeowners do not change with inflation rate , basically the normal interest rate emain fixed.

Now, the interest payable by homeowner be 'r1' and the nominal interest rate be 'n' made against the inflation rate 'ie'

Hence, rate payable: r1=n-ie

Now, actual inflation rate is higher than ie (that is ia)

r2 = n-ia (where ia > ie)

This means that r1 > r2 and the homeowner has to pay lesser amount in real terms

Hence, increase in inflation affects homeowners obtaining fixed rate mortgages positively

b) The bankers that lend money in 1960's would suffer in terms of creditors due to the unexpected hike in inflation rate.
This is because the interest rate charged by the bank was adjusted to a certain anticipated inflation rate. The unprecedented surge in inflation leads to a fall in the real value of money and the amount paid back to the bank against the lending has lesser value than accounted.
This leads to a loss for the bank in terms of creditors or lenders.

Rahul Sunny answered 2 years ago
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