Textbook Problem

Suppose that a borrower and a lender agree on the nominal interest rate to be paid on a loan. Then inflation 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 gain or lose?

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?

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