Bill wants to borrow 100 from John John wants to make 6 real

Bill wants to borrow $100 from John. John wants to make 6% real return on his money, so they both agree on a 6% interest rate paid next year. Neither anticipate the actual -2% inflation rate next year. In this case:

A. Bill will pay 6% in nominal interest rate.

B. Bill will pay 8% in real interest rate.

C. John is better off.

D. all of the above

Solution

Inflation rate represents the percentage change in increase in general price level from a period of time to another.

Here inflation rate is negative value which represent deflation that is general price level decreased from previous year to now that is from the period of borrowing by Bill and to the period of payment of interest. As now prices has decline, with 6% interest rate amount that is $60 John will be able to purchase more goods when compared to the amount og good he would have been purchased in previous year. Hence real income has increased because of decrease in price level. Thus John is better off.

And although Bill will pay 6% in interest but it is actually equal to 6% + 2% = 8% of interest rate thus Bill will pay 8% in real terms but 6% in monetary terms.

Thus option D (All of the above) is correct.