Question

In: Economics

Your friend is currently engaged in a multi-level marketing pyramid scheme, where he/she has opened up...

Your friend is currently engaged in a multi-level marketing pyramid scheme, where he/she has opened up a storefront selling Cutco knives, essential oils, and Herbalife products. Suppose that your friend borrowed $75,000 from a bank at a fixed interest rate of 5.25% in order to fund business operations.

a) Assume that after your friend takes out the loans, inflation significantly rises as he/she starts paying back the loans. Does the rise in inflation benefit or harm your friend? Why?

b) Suppose that inflation significantly decreases instead. Does the drop in inflation benefit or harm your friend? Why?

Solutions

Expert Solution

A.

Rise in inflation is going to benefit the friend, because it decreases the real value of loan repayment amount even if the nominal value of the loan repayment amount remains sames. So, in real value terms, the friend gets more from the bank and due to inflation, the real value of money returned to the bank decreases and it is going to hurt the bank and benefit my friend.

For example, my friend pays $1000 as EMI as a part of loan repayment schedule, then due to higher inflation rate, its purchasing power of $1000 decreases ( than the time when inflation was not increased) and its real value lowers. It benefits the friend.

==

B.

If there is a significant decrease in the inflation rate, then it is going to harm the friend. It is due to the reason that the real value of money increases due to decrease in inflation, even if the nominal value remains same. It is going to benefit the bank and hurt my friend.

Now, if my  friend pays $1000 as EMI as a part of loan repayment schedule, then due to decrease in inflation, the purchasing power of money ($1000) significantly increases. It means that friend is paying more real value than he has received. So, it is going to harm my friend.

Rahul Sunny answered 1 year ago
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