Determine if each statement is true or false.
True
False
Answer Bank
Real interest rates will never go negative.
If inflation is higher than the nominal interest rate, the real interest rate is negative.
Lenders lose when inflation is higher than expected.
Loan contracts specify the nominal interest rate.
Borrowers gain when inflation is lower than expected.
The correct answer and explanation is :
Here are the answers to the statements, followed by detailed explanations for each:
- Real interest rates will never go negative.
False
Real interest rates can go negative when inflation is higher than the nominal interest rate. In such a case, lenders actually lose purchasing power because the value of the money they receive in the future is less than expected due to inflation. A negative real interest rate essentially means that the lender is paying the borrower for the privilege of lending. - If inflation is higher than the nominal interest rate, the real interest rate is negative.
True
The real interest rate is calculated by subtracting the inflation rate from the nominal interest rate. If inflation exceeds the nominal interest rate, the real interest rate becomes negative, meaning that the purchasing power of the money lent is eroded by inflation. - Lenders lose when inflation is higher than expected.
True
Lenders lose when inflation is higher than expected because they are paid back in money that is worth less than anticipated. If the inflation rate rises unexpectedly, the value of the payments they receive decreases, meaning they lose purchasing power. - Loan contracts specify the nominal interest rate.
True
Loan contracts typically specify the nominal interest rate, which is the rate agreed upon at the time of the loan. This is the rate borrowers will pay lenders, but it does not account for inflation, which affects the real interest rate. - Borrowers gain when inflation is lower than expected.
True
Borrowers gain when inflation is lower than expected because they repay their loans with money that has a higher purchasing power than anticipated. Essentially, the value of the money they repay is worth more than it would have been if inflation had been higher.
Explanation Summary:
- Real Interest Rate: This is the nominal interest rate adjusted for inflation. It reflects the actual purchasing power of the interest earned or paid. When inflation exceeds nominal interest, real interest rates become negative, meaning the lender loses.
- Lenders and Borrowers: Lenders face a loss when inflation rises unexpectedly because it erodes the value of money. Borrowers benefit from unexpected inflation because they repay their loans with money that has less purchasing power.