Assume that the real rate of interest is 5 percent and a lender charges a nominal interest rate of 15 percent. If a borrower expects that the rate of inflation next year will be 10 percent and the actual rate of inflation next year is 12 percent:
A) neither the borrower nor the lender benefits from inflation.
B) both the borrower and the lender lose from inflation.
C) the borrower benefits from inflation, while the lender loses from inflation.
D) the lender benefits from inflation, while the borrower loses from inflation.

Question

Quizplus · Accepted Answer

Inflation reduces the value of money over time. If the borrower expects that the rate of inflation will be 10 percent and it turns out to be 12 percent, then the borrower benefits because they are paying back the loan with money that is worth less than when they borrowed it. On the other hand, the lender loses out because they are receiving payments in money that is worth less than when they lent it out. The nominal interest rate of 15 percent is higher than the real rate of interest of 5 percent, but in this case, inflation erodes the value of the interest payments received by the lender. Therefore, the borrower benefits from inflation, while the lender loses from inflation.

Assume That the Real Rate of Interest Is 5 Percent