Answer to Question #323196 in Macroeconomics for judAH

Question

suppose that a borrower and a lender agree on nominal interest rate to be paid on a loan then inflation turns out to be higher than they both expected

Answer 1

The real interest rate is the interest rate that has been adjusted to account for inflation. In a perfect world, the difference between the nominal interest rate and the inflation rate is different. The actual interest rate is obtained by subtracting the nominal interest rate from the inflation rate.

i.e., Nominal interest rate – inflation rate Equals real interest rate

When inflation is more than projected, the actual interest rate on this debt falls lower than anticipated. The real interest rate gauges the purchasing power of interest on borrowed funds.

 A high inflation rate is a double-edged sword that impacts both the borrower and the lender's gains. However, the significant unanticipated inflation results in a loss for a lender. Because the real interest rate is lower than projected, the lender is on the receiving end, and a drop in the interest rate means the interest received by the lender has less purchasing power. As a result, the lender loses, and the borrower profits since the real interest rate are lower than projected. The borrower, who is also responsible for repaying the loan, benefits from the fact that the dollar value is lower than projected.