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.
Does the lender gain or lose from this unexpectedly high inflation? Does the borrower gain or lose?
Think it through. Then take a shot.
lender lose?
borrowers gain?
You are correct! In the scenario where inflation turns out to be higher than expected, the lender tends to lose while the borrower gains.
To understand why, let's break it down. When the borrower and lender agree on a nominal interest rate, it is typically based on their expectations of inflation. The nominal interest rate is the rate charged without taking inflation into account. However, inflation erodes the purchasing power of money over time, and higher than expected inflation diminishes the value of the money repaid by the borrower.
Here's why the lender loses:
1. Fixed return: Lenders expect a fixed return on their loan, which includes the nominal interest rate. If inflation is higher than expected, the lender's real return (the return adjusted for inflation) decreases because the money the lender receives in repayment has less purchasing power.
2. Diminished purchasing power: The lender, upon receiving the repayment, may find that the money repaid is worth less in real terms than they anticipated due to the higher inflation. This means they can buy fewer goods or services with that money, resulting in a loss of purchasing power.
On the other hand, the borrower gains:
1. Reduced real burden: When inflation is higher than expected, the borrower benefits because they can repay the loan with money that has diminished real value. They essentially reduce the economic burden of repaying the loan, as they pay it back with less valuable currency.
2. Favorable lending terms: Higher inflation can also lead to lenders increasing nominal interest rates in anticipation of inflation. However, if the borrower has already agreed to a fixed nominal interest rate, they may end up paying back their loan with cheaper money, effectively acquiring the loan at a lower real interest rate.
It's important to note that these outcomes are based on the assumption that inflation is higher than expected. If inflation turns out to be lower than anticipated, the reverse effects would occur.