Inflation and deflation: Practice Questions

Which of the following best describes inflation?

Suppose a borrower takes out a loan with a nominal interest rate of $$8\%$$ per annum. If the actual inflation rate turns out to be $$5\%$$ over the loan period, but the borrower and lender had expected an inflation rate of $$3\%$$ at the time the loan was issued, what is the realized real interest rate for this loan?

An economy experiences a prolonged period where the actual inflation rate consistently exceeds the inflation rate anticipated by the public and factored into long-term nominal contracts. The central bank attempts to manage this, but inflationary pressures remain strong. Which of the following is the most significant long-term consequence of this persistent unanticipated inflation on the efficiency of resource allocation in the economy?

Deflation refers to a situation where:

Suppose the nominal interest rate is \( 7\% \) and the actual inflation rate is \( 9\% \). Which of the following statements is true regarding this situation?

What is inflation? Explain how unanticipated inflation can redistribute wealth between debtors and creditors.

A government issues long-term bonds with a fixed nominal interest rate. If actual inflation turns out to be significantly higher than the inflation rate anticipated by both investors and the government at the time of issuance, explain the redistributive effects on the government (as a borrower) and the bondholders (as lenders), referencing the concept of real interest rates.

An economy experiences a period where the actual inflation rate turns out to be 10%, significantly higher than the initially expected rate of 2%. Analyze the redistributive effects of this unanticipated inflation on the following groups, explaining whether they gain or lose in real terms:
(i) individuals who primarily rely on fixed nominal pensions,
(ii) borrowers with outstanding long-term fixed-rate mortgage loans, and
(iii) savers who hold significant amounts of bank deposits earning a fixed nominal interest rate.

(a) Define inflation and deflation.

(b) Explain the relationship between the nominal interest rate, the real interest rate, and the expected inflation rate. State the relevant equation.

(c) Suppose a bank lends a customer HK$100,000 for one year at a nominal interest rate of 5%. Both parties initially expected the inflation rate to be 2% for the year. However, the actual inflation rate turns out to be 4%.

(i) Calculate the actual real interest rate, showing your steps.

(ii) Explain whether the borrower or the lender gains from this unanticipated change in inflation, and briefly elaborate on why.