In each of the following examples, identify whether the person or institution will be penalized by...

In each of the following examples, identify whether the person or institution will be penalized by inflation and, if so, why.

a. Mosie borrows $5,000 for her college expenses at an interest rate of 4 percent to be paid off over five years, during which time the inflation rate averages 6 percent.

b. Oscar invests $3,000 in securities that pay 5.3 percent anually for 10 years, and the inflation rate during that time averages 6.4 percent.

c. The Lilyton National Bank commits to $10 million in 15-year mortgages at an average mortgage rate of 4.5 percent. The inflation rate averages 6 percent over this 15-year period.

d. Barney bought a house in 2006 for $100,000 that he is now selling for $200,000. During this time the inflation rate has averaged 3 percent.

Solutions

Expert Solution

a) As the expected rate of inflation is more than the received inflation rate the lender is penalized. In this case, the inflation will be 6% and the interest rate is only 4%. It will cause the transfer of wealth by 2% from the institution i.e. the lender to the borrower. The institution will be penalized.

b) Oscar is penalized. as the expected inflation rate is higher than the interest rate received by Oscar. The real value of money he has received is much less than he has invested.

c) The bank is penalized, again, in this case, the inflation rate is more than the interest rate receive that will reduce the value of real money and the lender will be penalized.

d) Barney is in benefit. He is selling the house at a benefit of 100% in the time period of 12 years. for the money to lose 100% value in that time period the inflation should be 5.83% but it was only 3%. No losers here, Barney is beneficial.

Rahul Sunny answered 1 year ago

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