Question

Q) Given that for any loan, nominal interest rate (not real interest is charged) is charged, suppose that people expect inflation to equal 3 percent, but in fact prices rise by 5 percent after the loan contract is signed, [I_nominal = I_real + Expected Inflation].To the best of your ability, describe how this unexpectedly high inflation rate would help or hurt the following:

a. the government

b. a homeowner with a fixed-rate mortgage

c. a union worker in the second year of a labour contract

d. a college or university that has invested some of its endowment in government bonds

Answer 1

A.

It favors the government. It happens in two ways. A higher inflation rate is the result of increase in AD and government is able to collect more tax revenues due to higher income level. Further, the government has the reduced value of real DEBT upon it, even if the nominal value of debt remains the same.

B.

It favors these homeowners, because they pay the fixed amount in EMI, that has lower real value, due to unexpected rise in inflation. Though, the nominal value of EMI, remains same.

C.

It hurts the union workers, because wage is fixed as per the contract, but real value of wage decreases. Though, the union workers get the same nominal wage.

D.

It hurts these colleges and universities, because these institutions get decreased real return upon bonds, due to unexpected rise in inflation.