Question

a) Explain who wins and who loses if inflation is less than what the market expected. Why?

b) Which one is more economically important, ex-ante or ex-post real interest rates? Why?

Answer 1

a) When inflation rate is less than expected inflation rate the lender wins and borrower loses because when lender lends the money they take into consideration the future expected inflation, and fixed the nominal interest rate according to the expected inflation rate. When actual inflation is less than expected its value of money increases and purchasing power of money increases.

let take the example Real interest rate = Nominal interest rate - actual Inflation rate

let nominal interest rate = 10% Expected inflation rate = 5% and actual inflation rate = 3%

condition 1. When expected inflation rate = actual inflation rate = 5%

Real interest rate = 10 - 5 = 5%

Condition 2 when Expected inflation rate > actual inflation rate

Then the Real interest rate = 10 - 3 = 7%

In means in the second case the lender get more return on their money.

b) If we talk in simple words the ex - ante real interest rate is the difference between the nominal rate and the expected inflation rate. In other words Ex ante real interest rate = Nominal interest rate - Expected inflation rate.

The ex post real interest rate is the difference between the nominal rate and the actual interest rate. In other words ex poste real interest rate = Nominal interest rate - actual inflation rate.

The ex ante real interest rate is important because while we taking loan and purchasing the bonds we take into consideration the ex ante real interest rate not the ex post real interest rate. The other reason is ex ante show the future expectation of return. So ex ante real interest rate is important.