Question

You take out student loans to help pay for your degree at a 5% annual interest rate. Assume the bank expected inflation to average 3% per year. What real interest rate did they expect to earn from your loan? What happens if inflation is actually 5% per year? Who is better off if inflation is higher than expected? What if it is lower than expected? Why?

Answer 1

When annual interest rate is 5% and inflation rate is 3%, then:

Real interest rate = (1+5%)/(1+3%) - 1

Real interest rate = 1.94%

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If inflation rate is 5%

Then,

Real interest rate = (1+5%)/(1+5%) - 1

Real interest rate = 0%

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Borrower is better off, when inflation rate is higher than expected. In this case, it is the student. It happens because real value of loan repayment decreases, even though the nominal value remains same.

When inflation rate is lower than expected, then lender is better off, because real value of loan repaid to them, has increased and it is higher than the expected.