Question

9. Suppose that a borrower and a lender agree on the nominal interest rate to be paid on a loan. Then infla- tion turns out to be higher than they both expected. a. Is the real interest rate on this loan higher or lower than expected? b. Does the lender gain or lose from this unexpectedly high inflation? Does the borrower c. Inflation during the 1970s was much higher than most people had expected when the decade began. How did this affect homeowners who obtained fixed-rate mortgages during the 1960s? How did it affect the banks that lent the money? gain or lose? To find additional study resources, visit cengagebrain.com, and search for "Mankiw."

Answer 1

a. Lower

Real interest rate = Nominal interest rate – inflation

So, when inflation is higher than expected, then real interest rate is lower.

b. The lender loses and the borrower gains because the borrower is repaying the loan with dollars that are worth less than was expected.

c. Homeowners (i.e. the borrowers) in the 1970s who had fixed-rate mortgages (nominal interest rate maintains constant) from the 1960s benefited from the unexpected inflation, while the banks (lenders) that made the mortgage loans were harmed.

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