Loretta agrees to lend Ted $500,000 to buy computers for his consulting firm. They agree to a nominal interest rate of 8%. Both expect the inflation rate to be 2%
(a) Calculate the expected real interest rate.
(b) If inflation turns out to be 3% over the life of the loan, what is the real interest rate? Who gains from unexpectedly high inflation, Loretta or Ted?
(c) If inflation turns out to be 1% over the life of the loan, what is the real interest rate? Who gains from unexpectedly low inflation, Loretta or Ted?
(a) 8% - 2% = 6%.
(b) 8% - 3% = 5%. Ted gains from unexpectedly high inflation, because he repays the loan with dollars that aren't worth as much as was expected.
(c) 8% - 1% = 7%. Loretta gains from unexpectedly low inflation, because she gets repaid with dollars that are worth more than was expected.
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