MACROECONOMICS QUESTION

Question

Suppose a borrower signs a contract to borrow $100 from a lender and pay back $120 in one year. When this contract is signed, the inflation rate is 10%. After it is signed, there is an unexpected increase of inflation rate to 20%.

Before the unexpected increase in the inflation rate, the nominal interest rate of this contract is ____ % (please write only 0, 10 or 20), and the real interest rate of this contract is _____% (please write only 0, 10 or 20). After the unexpected increase in the inflation rate, the nominal interest rate of this contract is _____% (please write only 0, 10 or 20) and the real interest rate of this contract is _____% (please write only 0, 10 or 20). This means that in real terms, the borrower pays _____  (please write more or less) to the lender.

Answer 1

To answer this question, you must use the Fisher equation, which is:

Real interest rate = Nominal rate - inflation rate.

So initially, the nominal rate is 20% and the real interest rate is 10%. However, when the inflation rate rises unexpectedly, its a win for the borrower and loss for the lender. They money that will be paid back is worth less than the money that is borrowed. The nominal interest rate won't change, but the real interest rate depends on the inflation rate. So recalculate the real interest rate as: 20%-20% = 0% This means in real terms the borrower pays less than the lender.