Suppose expectations are such that the rate of inflation for the foreseeable fut
ID: 1219567 • Letter: S
Question
Suppose expectations are such that the rate of inflation for the foreseeable future is pegged at 2%. Further suppose that lenders and investors are seeking a 4% real return.
37. Money will be lent at what rate of interest under this scenario?
A. 2%
B. 8%
C. 4%
D. 6%
E. Impossible to determine.
38. Suppose that 4 years from now it is obvious that the actual rate of inflation averaged 1%. Which of the following statements is correct regarding loans initially granted with 4-year terms?
A. Both lenders and borrowers meet their objectives.
B. There is an arbitrary redistribution of income from lenders to borrowers.
C. There is no redistribution of income resulting from the loans.
D. There is an arbitrary redistribution of income from borrowers to lenders.
Explanation / Answer
(37) (D)
Required interest rate = Real interest rate + Expected inflation rate = 4% + 2% = 6%
(38) (D)
Higher inflation benefits borrowers and harms lenders. So, when actual inflation is lower than expected inflation, it benefits lenders and harms borrowers, and there is re-distribution of income from borrowers to lenders.