Eliza wants to borrow $100 from Sandy. Sandy wants to make 4% real return on his money, so they both agree on a 4% interest rate paid next year. Eliza and Sandy did not anticipate any inflation, yet the actual inflation turned out to be -5% next year. In this case,
A) Eliza will pay an 9% real interest rate.
B) Sandy is better off.
C) Eliza will pay a 4% nominal interest rate.
D) all of the above

Question

Quizplus · Accepted Answer

The real interest rate can be calculated using the formula: real interest rate = nominal interest rate - inflation rate. Given a nominal interest rate of 4% and an inflation rate of -5%, the real interest rate is 4% - (-5%) = 9%. Sandy benefits because the value of the money returned has increased more than expected due to deflation (negative inflation). Eliza will indeed pay a 4% nominal interest rate, as agreed, but the real value of what she pays back is higher due to deflation.

Eliza Wants to Borrow $100 from Sandy