Final answer:
c) Remains constant
The Fisher effect hypothesis implies that the real rate of return remains constant as inflation increases because nominal interest rates adjust to compensate for inflation expectations. Borrowers with fixed interest rates benefit from unexpected inflation, while lenders suffer. ARMs adjust to higher inflation, leading to an increased nominal interest rate.
Step-by-step explanation:
According to the Fisher effect hypothesis, the real rate of return remains constant as inflation increases. This economic theory postulates that the nominal interest rates adjust to the expected rate of inflation to maintain the real rate of return. When inflation is anticipated to increase, lenders demand higher nominal rates to compensate for the decreased purchasing power of future interest and principal payments. Conversely, if a borrower has a fixed interest rate and inflation rises unexpectedly, the lender loses and the borrower gains because the real rate of return has effectively decreased to the lender and the repayment is made in less valuable dollars.
For example, if someone takes out a loan at a 9% interest rate when the inflation is at 3%, the real interest rate is 6%. Should the inflation rate increase to 9%, the real interest rate will drop to 0%, benefiting the borrower. Likewise, ARMs (Adjustable Rate Mortgages) can fluctuate with inflation rates, leading to higher nominal rates during periods of higher inflation. Fixed-rate mortgages, however, provide a benefit to the borrower when inflation increases, as the real interest rate declines.