Question

In: Economics

6. Unanticipated changes in the rate of inflation Initially, Neha earns a salary of $400 per...

6. Unanticipated changes in the rate of inflation

Initially, Neha earns a salary of $400 per year and Lorenzo earns a salary of $200 per year. Neha lends Lorenzo $100 for one year at an annual interest rate of 20% with the expectation that the rate of inflation will be 16% during the one-year life of the loan. At the end of the year, Lorenzo makes good on the loan by paying Neha $120. Consider how the loan repayment affects Neha and Lorenzo under the following scenarios.

Scenario 1: Suppose all prices and salaries rise by 16% (as expected) over the course of the year. In the following table, find Neha's and Lorenzo's new salaries after the 16% increase, and then calculate the $120 payment as a percentage of their new salaries. (Hint: Remember that Neha's salary is her income from work and that it does not include the loan payment from Lorenzo.)

Value of Neha's new salary after one year

The $120 payment as a percentage of Neha's new salary

Value of Lorenzo's new salary after one year

The $120 payment as a percentage of Lorenzo's new salary
                       

Scenario 2: Consider an unanticipated decrease in the rate of inflation. The rise in prices and salaries turns out to be 5% over the course of the year rather than 16%. In the following table, find Neha's and Lorenzo's new salaries after the 5% increase, and then calculate the $120 payment as a percentage of their new salaries.

Value of Neha's new salary after one year

The $120 payment as a percentage of Neha's new salary

Value of Lorenzo's new salary after one year

The $120 payment as a percentage of Lorenzo's new salary
                       

An unanticipated decrease in the rate of inflation benefits   and harms   .

Solutions

Expert Solution

Scenario 1:

Value of Neha's new salary after one year = 400 + 16%(400) = 400 + 64 = 464

The $120 payment as a percentage of Neha's new salary = (120/464)*100 = 25.86%

Value of Lorenzo's new salary after one year = 200 + 16%(200) = 200 + 32 = 232

The $120 payment as a percentage of Lorenzo's new salary = (120/232)*100 = 51.72%

Scenario 2:

Value of Neha's new salary after one year = 400 + 5%(400) = 400 + 20 = 420

The $120 payment as a percentage of Neha's new salary = (120/420)*100 = 28.57%

Value of Lorenzo's new salary after one year = 200 + 5%(200) = 200 + 10 = 210

The $120 payment as a percentage of Lorenzo's new salary = (120/210)*100 = 57.14%

Neha; Lorenzo
(Unaticipated decrease in inflation benefits lenders and harms borrowers.)

Rahul Sunny answered 2 years ago
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