Boris Borrower and Lynn Lender agree that Lynn will lend Boris \(\$ 10,000\) and that Boris will repay the \(\$ 10,000\) with interest in one year. They agree to a nominal interest rate of \(8 \%,\) reflecting a real interest rate of \(3 \%\) on the loan and a commonly shared expected inflation rate of \(5 \%\) over the next year. a. If the inflation rate is actually \(4 \%\) over the next year, how does that lower-than-expected inflation rate affect Boris and Lynn? Who is better off? b. If the actual inflation rate is \(7 \%\) over the next year, how does that affect Boris and Lynn? Who is better off?

Boris borrows \( \$ 10,000\) from Lynn, with a nominal interest rate of \(8 \%.\) The real interest rate agreed upon is \(3 \%\) and the expected inflation rate is \(5 \%.\) Note that the nominal interest rate is the sum of the real interest rate and the expected inflation rate, i.e., \(8\% = 3\% + 5\%\).

In this scenario, the actual inflation rate is lower than the expected inflation rate (\(4\%\) instead of \(5\%\)). We need to analyze how this affects Boris and Lynn and determine who is better off. First, calculate the actual nominal interest rate: Actual nominal interest rate = Real interest rate + Actual inflation rate Actual nominal interest rate = \(3\% + 4\% = 7\%\) Now, calculate the total amount Boris has to pay back: Total amount to pay back = Principal + (Principal * Actual nominal interest rate) Total amount to pay back = \(10000 + (10000 * 7\%) = 10000 + 700 = \$ 10,700\) In this scenario, Boris has to pay back a lesser amount compared to the initial agreement based on the expected inflation rate. Therefore, Boris is better off since he gains, and Lynn is worse off as she experiences a loss.

In this scenario, the actual inflation rate is higher than the expected inflation rate (\(7\%\) instead of \(5\%\)). We need to analyze how this affects Boris and Lynn and determine who is better off. First, calculate the actual nominal interest rate: Actual nominal interest rate = Real interest rate + Actual inflation rate Actual nominal interest rate = \(3\% + 7\% = 10\%\) Now, calculate the total amount Boris has to pay back: Total amount to pay back = Principal + (Principal * Actual nominal interest rate) Total amount to pay back = \(10000 + (10000 * 10\%) = 10000 + 1000 = \$ 11,000\) In this scenario, Boris has to pay back a higher amount compared to the initial agreement based on the expected inflation rate. Therefore, Boris is worse off as he experiences a loss, and Lynn is better off since she gains.