Describe how a lender can lose during inflation if the inflation is unanticipated and the loan is a fixed-interest-rate loan. How would a variable-interest-rate loan (one that adjusts over the contract period) eliminate these loses?
What will be an ideal response?
Lenders require compensation for inflation when charging interest. The nominal interest rate (also called the market interest rate) they charge equals the real rate of interest plus the expected inflation over the loan contract period. The interest rate they charge is determined at the beginning of the loan period, so the charge for inflation is a prediction of what the lender thinks inflation will be over the contract period. If the loan has a fixed rate, the interest rate does not change over the period of the loan. If the lender under-predicts inflation, then the lender will not be compensated enough for the loss in purchasing power due to inflation. The lender will lose to the extent of the under-prediction.
If the loan is a variable-rate loan, the interest rate can be adjusted upwards if the lender under-predicts inflation. This can lower the loss to the lender. The variable rate automatically adjusts for mistakes in predicting inflation. The more frequently the rate can be adjusted, the less the lender's losses.
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What will be an ideal response?
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