Answer to Question #126154 in Macroeconomics for Reina

Question

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.
Is the real interest rate on this loan higher or lower than expected?
Does the lender gain or lose from this unexpectedly high inflation? Does the borrower gain or lose?
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?

Answer 1

Answer

Is the real interest rate on this loan higher or lower than expected?

Real interest rate is the interest rate adjusted to accommodate the effect of inflation. It is ideally the difference between the nominal interest rate and the rate of inflation. The real interest rate is computed as the difference between the nominal interest rate and the inflation rate. i.e: Real interest rate = nominal interest rate – inflation rate

When the inflation turns out to be higher than expected, the real interest rate on this loan decreases to a point lower than expected. The real interest rate measures the purchasing power of the interest for the money loaned out. If nominal interest rate was 9 percent for example and people expect that the inflation will be 6 percent, then the market has an expected real interest of 3 percent (9%-6%). However, if in case inflation turns out to be 7 percent, the real interest rate will be equal to 9 percent minus 7 percent which is equal to 2 percent. This inflation rate is less than the expected 3 percent inflation rate.  Fischer effect provides that an increase in expected inflation drives up the nominal interest rate which leaves the expected real interest unchanged.

Does the lender gain or lose from this unexpectedly high inflation? Does the borrower gain or lose?

The unexpectedly high inflation rate is a double edged sword that affects the gains of the borrower and the lender at the same time. For a lender however, the unexpectedly high inflation leads to a loss. The lender is on the receiving end since the real interest rate is lower than expected and a declined on the interest rate translates to a lower purchase power of the interest that the lender will receive. Hence, as a result of the lower real interest rate is less than the expected, the lender loses and the borrower gains. The borrower who happens to be the party repaying the loan gains from the fact that the dollar value is worth less than was expected. 

Effect on the homeowners  and banks following the Inflation during the 1970s

During the 1970s, the homeowners were the borrowers who took out fixed-rate mortgages while the banks were the lenders. The homeowners (borrowers) who had fixed-rate mortgages from prior years including the 1960s benefited from the unexpected inflation, while the banks who were the lenders lost significantly in gains as a result of the unexpected inflation during the 1970s. The damage on the gains from the mortgage loans befell the banks.