Suppose that Bill expects the inflation rate to be 10 percent and he borrows $8,000 from a local bank to purchase a car. He agrees to pay the loan back in a year at an interest rate of 10 percent. But over the following 12 months, the inflation rate turns out to be 5 percent. This implies the bank will experience an increase in real income.

Question

Quizplus · Accepted Answer

The bank will experience an increase in real income because the actual inflation rate (5%) is lower than the expected inflation rate (10%). This means the real interest rate is higher than anticipated, increasing the bank's real income from the loan.

Suppose That Bill Expects the Inflation Rate to Be 10