Question

In which of the following situations would you prefer to be borrowing?

a) the interest rate is 6% and the expected inflation rate is 6%

b) the interest rate is 5% and the expected inflation rate is 3%

c) the interest rate is 7% and the expected inflation rate is 13%

d) the interest rate is 11% and the expected inflation rate is 2%

Please explain. Thank you : )

Answer 1

When we are borrowing a certain sum, we will be creating value when the interest rate is less than the inflation rate

Borrow: Inflation> Interest rate.

Reason:

1. When the inflation rate is high then overall prices increase more than what the person has to pay the same amount of interest and principal.
2. It means we will be less in terms of purchasing power.
3. So the financing becomes cheap during high inflation and vice versa.

a) the interest rate is 6% and the expected inflation rate is 6%.

Can Borrow/not Borrow, as Inflation= Interest rate.

b) the interest rate is 5% and the expected inflation rate is 3%

Not borrow as: Inflation< Interest rate.

c) the interest rate is 7% and the expected inflation rate is 13%

Can Borrow: Inflation> Interest rate.

d) the interest rate is 11% and the expected inflation rate is 2%

Not borrow as: Inflation< Interest rate.