Question

Describe how a lender can lose during inflation if the inflation is unanticipated and the loan is a fixed-interest-rate loan.

How would a variable-interest-rate loan (one that adjusts over the contract period) eliminate these loses?

Answer 1

Ans -

1) When lender lends money which is at fixed-interest rate than after sometime when borrower returns that money when the inflation is increased then lender is at loss as now that money doesn't hold same value when it is adjusted with inflation. Because now price level has increased due to inflation.

For example - if lender lends $200 at fixed interest rate such that borrower will return $300 after sometime. Then after some time when borrower gives it back $300 and this time the inflation rate is increased than when it was lend. Earlier when money was lend 1 apple was of $50 which means $300 could have bought 6 apples now when lender gets its money back inflation has risen and 1 apple cost is $100 so now $300 will only bring 3 apple and not 6 apple like earlier due to price rise of apple. This example shows how fixed interest rate can lead to loss during inflation.

2) Variable Interest rate helps to prevent loss as when borrower will return the borrowed money it will not take fixed interest rate but interest rate of that year in which he/she is going to return the money. As this interest rate are adjusted according to market situation so lender will not at lost.