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Chapter 20: Problem 8

Suppose that Apple and the investors buying the firm's bonds both expect a 2 percent inflation rate for the year. Given this expectation, suppose the nominal interest rate on the bonds is 6 percent and the real interest rateis 4 percent. Suppose that a year after the investors purchase the bonds, the inflation rate turns out to be 6 percent, rather than the 2 percent that had been expected. Who gains and who loses from the unexpectedly high inflation rate?

Short Answer

Expert verified
The investors lose because of the reduced purchasing power of the money returned on their investment. Apple gains as they repay their debt with money that is worth less due to the increased inflation.

Step by step solution

01

Understand the concept

Understand the relationship between nominal interest rate, real interest rate and inflation rate. The nominal interest rate is sum of expected inflation rate and the real interest rate. It's given by the Fisher Equation: \(i = r + π\), where \(i\) is the nominal interest rate, \(r\) is the real interest rate, and \(π\) is inflation rate.
02

Find the expected nominal return

The expected nominal return on the bond is the nominal interest rate which is 6 percent according to the problem.
03

Calculate the actual inflation and real return

The actual inflation turned out to be 6 percent which is higher than the expected 2 percent. That means, the investors expected 4 percent as their real return, \(i - π = 6% - 2% = 4%\). But due to unexpected inflation, their real return ended up being less, \(i - π = 6% - 6% = 0%\). In essence, the real money returned has lower purchasing power than expected.
04

Determine who gains or loses

Higher than expected inflation leads to a reduction in the purchasing power of money returned on investment. The investors who purchased the company's bonds have therefore lost from the unexpectedly high inflation rate. Conversely, Apple who owes money to the investors in the form of bonds is now able to pay back the borrowed amount with money that is 'worth less', so Apple stands to gain from the unexpectedly high inflation.

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Most popular questions from this chapter

In his 2016 State of the Union address, President Barack Obama observed that in the previous 70 months, the U.S. economy had created "more than 14 million new jobs." Is it likely that the U.S. economy created only 14 million jobs during this time period? If not, what was President Obama referring to?

Briefly describe the three major measures of the price level.

If the economy is experiencing deflation, will the nominal interest rate be higher or lower than the real interest rate?

Which is a greater problem: anticipated inflation or unanticipated inflation? Briefly explain.

(Related to the Don't Let This Happen to You on page 681 ) Briefly explain whether you agree with the following statement: "I don't believe the government price statistics. The CPI for 2016 was \(240,\) but I know that the inflation rate couldn't have been as high as 140 percent in \(2016 . "\)
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