Suppose you negotiate a one-year loan with a principal of $1000 and the nominal interest rate...

Suppose you negotiate a one-year loan with a principal of $1000 and the nominal interest rate is currently 7 % . You expect the inflation rate to be 3 % over the next year When you repay the principal plus interest at the end of the year, the actual inflation rate is 2.5 % . Compute the ex ante and ex post real interest rate , who benefits from this unexpected decreasc in inflation? Who loses? Calculate and explain.

Solutions

Expert Solution

The ex ante real interest rate

The ex ante real interest is the difference between the nominal interest rate ( i ) and the expected inflation rate ( ^e).

Therefore, ex ante real interest is 4 %.

The ex post real interest rate

The ex post real interest is the difference between the nominal interest rate ( i ) and the actual inflation rate ( ).

Therefore, ex post real interest is 4.5 %.

Lender benefits from this unexpected decrease in inflation.

Borrower loses from this unexpected decrease in inflation.

Lender Benefits

The difference between the ex ante and ex post real interest rate 0.5%.

Therefore, Lender Receive $5 more at the end of the year.

Borrower loses

Now, Borrower need to be pay $5 more at the end of the year.

Explanation

When there is unexpected decrease in inflation, Lender benefits because, now he receive more real returns at 4.5% of interest rate as compared to 4% interest rate.

On the other hand, unexpected decrease in inflation, Borrower loses because, now he need to pay more payment at 4.5% of interest rate as compared to 4% interest rate.

Rahul Sunny answered 11 months ago

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