Question

The current nominal market interest rate for a four-year car loan is 8 percent per year. At the time the loan is made the anticipated annual rate of inflation over the four year period is 3 percent per year. If the actual rate of inflation over the four year period turns out to be 5 percent per year then A. the real rate of interest actually earned by the lender will be 5 percent per year. B. the real rate of interest earned by the lender will be 3 percent per year. C. a borrower who borrowed money to buy a car at the 8 percent nominal rate will gain at the expense of the lender. D. both B and C E. both A and C

Answer 1

D. both B and C. This is the CORRECT choice

Real rate of return = Nominal Rate of return - Rate of inflation

The lender's assumed real rate of return at the time of lending = 8% - 3% = 5% but actually he ends up earning less returns at the rate of 8% - 5% = 3%. Option A is incorrect. Option B is correct and Option E becomes incorrect when we look at lenders point of view.

From borrower's point of view, when he borrowed, the lender was expecting to make a real return of 5% (8% - 3%) and that's why the lending rate was 8%. But if the real inflation rate was known as 5% at that time instead of projected inflation of 3%, the lending rate would have been 10% (5% + 5%). Thus, borrower ended up benefiting based on the anticipated and actual rate of inflation difference as money in his own hand remained more. So borrowers gain is lenders loss. Option C is also correct.

Since both options B and C are correct. Thus Option D is correct choice.