A small business owner has a line of credit from a bank with a nominal interest rate of seven percent
For several years, the price level has been rising at an annual rate of two percent, but the owner has just read in the newspaper that economists expect next year's inflation rate to be four percent or more. Assume that this owner may either continue the line of credit at seven percent, or renegotiate to alter both the size of the credit and the interest rate. What reason might there be for the owner to keep the credit terms as is? What argument might justify changing the credit agreement?
The expected increase in the inflation rate from two percent to four percent means a decrease in the real interest rate from five percent to three percent. The existing terms of the line of credit have become more favorable to the borrower. Since the bank's loan officers are aware of the change in expected inflation, renegotiation of the agreement must mean an increase in the nominal interest rate. Nonetheless, the bank might consider a new nominal interest rate somewhat lower than nine percent, so the real interest rate would be somewhat lower than five percent. The borrower will renegotiate only if she desires, and the bank is willing, to increase the size of the line of credit.
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