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Chapter 22: Problem 8

If inflation rises unexpectedly by \(5 \%,\) would a state government that had recently borrowed money to pay for new highway benefit or lose?

Short Answer

Expert verified
In conclusion, the state government that recently borrowed money to pay for a new highway would benefit from an unexpected 5% rise in inflation. The real value of their debt decreases to \(0.95X\) dollars, allowing them to pay back the loan with "cheaper" money, resulting in a net gain for the government due to a reduced debt burden.

Step by step solution

01

Understand the effect of inflation on borrowed money

Inflation refers to the rate at which the general level of prices for goods and services is rising, and subsequently, the purchasing power of currency is falling. When inflation rises unexpectedly, it means that the money's value decreases, which represents an advantage for borrowers as the real value of their debt decreases.
02

Determine the impact of a 5% rise in inflation on the loan

Since inflation has risen unexpectedly by 5%, the real value of the borrowed money has decreased. It is important to note that inflation affects both the principal and the interest payments on the loan. Let's assume the state government borrowed a sum of \(X\) dollars for the highway project. Due to the 5% rise in inflation, the state government's debt in real terms becomes \(0.95X\) dollars.
03

Evaluate the benefit or loss for the state government

The state government benefits from the rise in inflation as the real value of their debt has decreased. They can now pay back the loan with "cheaper" money, as the value of the currency has fallen. This results in a net gain for the state government because they can allocate more resources to other projects or public services due to the reduced debt burden. In conclusion, the state government that had recently borrowed money to pay for new highway construction would benefit from the unexpected rise of inflation by 5%. This is because the real value of their debt decreases, allowing them to pay back the loan with "cheaper" money.

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Most popular questions from this chapter

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