Question

If a bank offers a home loan with a fixed interest rate of 8 percent with an expected inflation rate of 4 percent, and the inflation rate ends up being 5 percent, which accurately describes the impact on the bank?

a. It benefited because the real interest rate increased by 1 percent.
b. It benefited because the real interest rate increased by 4 percent.
c. It lost financially because the real rate of interest decreased by 1 percent.
d. Its expected gains increased because the real rate of interest increased to 9 percent.
e. The bank's real interest rate was not impacted by the difference in the inflation rate.

Answer 1

The bank lost financially due to the real interest rate decreasing by 1 percent, as the real repayment value was less than expected when the actual inflation rate surpassed the expected rate.

Step-by-step explanation:

If a bank offers a home loan with a fixed interest rate of 8 percent with an expected inflation rate of 4 percent, and the inflation rate ends up being 5 percent, the bank's financial outcome is described as follows: The bank lost financially because the real rate of interest decreased by 1 percent. In this scenario, the real interest rate is the nominal interest rate minus the actual inflation rate. Originally, the bank expected to receive a real interest rate of 4 percent (8 percent nominal interest minus the expected 4 percent inflation). However, with the inflation rate rising to 5 percent, the real interest rate is reduced to 3 percent (8 percent nominal interest minus 5 percent inflation).

Remember that the real interest rate reflects the lender's earnings adjusted for inflation. When the actual inflation rate is higher than expected, the value of the repayments in real terms decreases, which is a disadvantage for the bank as the supplier of the financial capital. In essence, the borrower repays the loan with dollars that are worth less than originally anticipated, benefiting the borrower but negatively impacting the bank.