If inflation had long been 7% and was therefore expected to continue, then it unexpectedly increased to 4% inflation:
A)the real interest rate on loans issued just before the change occurred would decrease by three percentage points.
B)the real interest rate on loans issued just before the change occurred would increase by three percentage points.
C)the real interest rate on loans issued just before the change occurred would not change.
D)none of the above.

Question

If inflation had long been 7% and was therefore expected to continue, then it unexpectedly increased to 4% inflation:
A)​the real interest rate on loans issued just before the change occurred would decrease by three percentage points.
B)​the real interest rate on loans issued just before the change occurred would increase by three percentage points.
C)​the real interest rate on loans issued just before the change occurred would not change.
D)​none of the above.

Quizplus · Accepted Answer

If inflation had long been at 7%, lenders would have set their nominal interest rates accordingly to cover the expected inflation rate. So, a loan issued just before the change occurred would have a higher nominal interest rate than the new inflation rate of 4%. Therefore, the real interest rate (nominal interest rate minus inflation rate) on loans issued just before the change occurred would increase by three percentage points.

If Inflation Had Long Been 7% and Was Therefore Expected