Question

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Posted 6 months ago

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You borrow $\$ 200$ from the First Bank of Westeros to purchase Kraken repellant. The bank charges a fixed nominal interest rate of $18 \%$ per year and you will repay them in one year. You and the bank both anticipate that there will be $7 \%$ inflation. However, after the loan agreement is signed, the rate of inflation turns out to be $9 \%$.
Who is hurt by this unanticipated inflation, and why are they hurt by it?
Choose 1 answer:
(A) The bank is hurt because the value of what is repaid has decreased
(B) You are hurt because the value of what is repaid has decreased
(C) The bank is hurt because the value of what is repaid has increased
(D) You are hurt because the value of what is repaid has increased
(E) We cannot tell without more information
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Answer from Sia

Posted 6 months ago

Solution by Steps

step 1

Calculate the real interest rate before the unanticipated inflation: The real interest rate can be calculated using the formula $r = i - \pi_e$, where $r$ is the real interest rate, $i$ is the nominal interest rate, and $\pi_e$ is the expected inflation rate

step 2

Substitute the given values into the formula: $r = 18\% - 7\% = 11\%$

step 3

Calculate the real interest rate after the unanticipated inflation: Using the same formula, $r = i - \pi$, where $\pi$ is the actual inflation rate

step 4

Substitute the actual inflation rate into the formula: $r = 18\% - 9\% = 9\%$

step 5

Compare the expected and actual real interest rates: The actual real interest rate (9%) is lower than the expected real interest rate (11%). This means that the value of the money repaid is less than what was anticipated

step 6

Determine who is hurt by the unanticipated inflation: Since the bank receives money that is worth less in real terms than expected, the bank is hurt by the unanticipated inflation

Answer

A

Key Concept

Real Interest Rate and Inflation

Explanation

The real interest rate adjusts the nominal interest rate for the effects of inflation. When actual inflation is higher than expected, lenders like banks are hurt because the money they receive back has less purchasing power than anticipated.

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