Final answer:
The inflation premium is true and it serves to compensate investors for expected price increases, maintaining the real value of their investment returns.
Step-by-step explanation:
True, the inflation premium does compensate investors for expected price increases. The concept of inflation premium refers to the additional return that investors demand for the possibility that inflation will erode the value of their investment. For example, when someone invests in a bond, they anticipate not only the return of their principal but also compensation for delaying consumption, an adjustment for inflation, and a risk premium that accounts for the borrower's riskiness.
If the rate of inflation rises unexpectedly, those with fixed-interest investments may receive payments in dollars that have lost purchasing power, effectively reducing their real rate of return. Conversely, borrowers who have locked in a fixed interest rate benefit when inflation rises, as they repay their loans with dollars that are worth less than originally anticipated. Thus, the inflation premium is an important consideration both for lenders and borrowers in medium to long-term financial contracts and is critical for maintaining the real value of earnings from investments.