- A Lender Need Not Be Penalized By Inflation If The A. Long-Term Rate Of Inflation Is Less Than The Short-Term Rate Of Inflation. B. Short-Term Rate Of Inflation Is Less Than The Long-Term Rate Of Inflation C. Lender Correctly Anticipates Inflation And Increases The Nominal Interest Rate Accordingly. D. Inflation Is Unanticipated By Both Borrower And
The correct answer and explanation is:
The correct answer is C. Lender Correctly Anticipates Inflation And Increases The Nominal Interest Rate Accordingly.
Explanation:
When lenders make loans, they face the risk of inflation eroding the purchasing power of the money they will receive in the future. To protect themselves from the negative impact of inflation, lenders may adjust the interest rate they charge on loans. This adjustment is typically in the form of a higher nominal interest rate to account for the expected inflation over the life of the loan.
Inflation erodes the value of money over time. If inflation is high and not accounted for, the lender would be repaid with money that is worth less than what was originally loaned. Therefore, a lender must be able to anticipate future inflation rates to prevent this erosion of purchasing power.
In Option C, when a lender correctly anticipates inflation and increases the nominal interest rate accordingly, they ensure that the value of the repayments will remain comparable to the original loan amount, despite the inflation. For example, if the lender anticipates a 3% inflation rate over the term of the loan, they may increase the interest rate by 3% to ensure that they are compensated for the inflationary loss. This strategy is commonly used in fixed-rate loans, where the lender and borrower agree to a set interest rate over the life of the loan.
In contrast:
- Option A and Option B address the relationship between short-term and long-term inflation rates but don’t directly explain how a lender can adjust for inflation. Inflation risks are more concerning when expected to be high over the long-term, rather than short-term fluctuations.
- Option D assumes inflation is unanticipated, which increases the likelihood of a loss for the lender, as they have not adjusted the interest rate to compensate for the unanticipated inflation.
Thus, a lender who accurately predicts inflation can adjust their nominal interest rate to ensure that inflation does not erode the value of the money they lend.