Suppose that a borrower and a lender agree on the nominal interest rate to be paid on a loan. Then inflation turns out to be higher than they both expected. a. Is the real interest rate on this loan higher or lower than expected? b. Does the lender gain or lose from this unexpectedly high inflation? Does the borrower gain or lose? c. Inflation during the 1970 s was much higher than most people had expected when the decade began. How did this unexpectedly high inflation affect homeowners who obtained fixed-rate mortgages during the 1960 s? How did it affect the banks that lent the money?

Understanding the nominal interest rate is essential for anyone working with loans or savings. Essentially, the nominal interest rate is the percentage increase in money that the borrower pays the lender, not taking into account any other external factors such as inflation.

Let's say you take out a loan with an annual nominal interest rate of 5%; you would expect to pay back an additional 5% of the amount borrowed each year. However, this rate does not reflect the true cost or gain of the loan, because it doesn't consider the changing value of money over time due to inflation. If prices are rising, the money being paid back is worth less than when it was borrowed. To understand the actual value, one needs to look at the real interest rate.

In the given exercise, the unexpected rise in inflation affects the nominal interest rate's effectiveness to represent the real cost of borrowing. A crucial concept to remember here is that while nominal interest rates are agreed upon at the outset of a loan, they can sometimes be misleading when economic conditions change unexpectedly.

Inflation is a critical economic concept that represents the rate at which the general price level of goods and services is rising, and, subsequently, purchasing power is falling. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.

Consider inflation like a silent thief that erodes the value of money over time. If you stuff cash under your mattress, you might find that after a few years, it buys you less than before. That's inflation at work. The inflation rate can be quantified as an annual percentage, showing how much quicker prices are rising compared to the previous year.

In our exercise example, higher-than-expected inflation means that each dollar is worth less. In terms of loans, this can erode the real worth of the money the lender gets back, or similarly, reduce the real burden of debt for the borrower. High inflation, therefore, influences the real interest rate in a way that cautions lenders and benefits borrowers, assuming the nominal interest rate doesn't adjust to these changing economic conditions.

A fixed-rate mortgage is a type of loan where the interest rate remains the same throughout the entire term of the loan, irrespective of market fluctuations. For homeowners, this means that the monthly mortgage payments are predictable and unaffected by rising or falling interest rates in the broader economy.

During the period of high inflation in the 1970s, as described in the exercise, those with a fixed-rate mortgage from the 1960s found themselves with an advantageous financial situation. As the inflation rate increased, their consistent mortgage payments became less burdensome in real terms, because each payment was made with dollars that were less valuable than when the loan was originated.

This scenario exemplifies the benefit of locking in a fixed-rate mortgage during periods of stable or low-interest rates before a significant increase in inflation. On the other hand, lenders who provided these fixed-rate mortgages faced the downside as they received repayments that, in real terms, were worth less than initially valued, reducing the overall profitability of the loans they issued.