Final answer:
The stated interest rate of a loan doesn't take inflation into account. The real interest rate is the nominal interest rate minus the rate of inflation. Ignoring inflation can have consequences for borrowers and lenders.
Step-by-step explanation:
The stated interest rate of a loan, also known as the nominal interest rate, does not take inflation into account. The real interest rate is the nominal interest rate minus the rate of inflation. For example, if the nominal interest rate is 7% and the rate of inflation is 3%, the borrower effectively pays a 4% real interest rate. However, if there is deflation of 2%, the real interest rate would be 9%.
Ignoring inflation when calculating interest rates can have significant consequences. Unexpected deflation can result in borrowers not being able to repay their loans, which can negatively impact banks and lead to a decline in aggregate demand and possibly recession.
However, inflation can sometimes benefit borrowers. When inflation is higher than the fixed interest rate on a loan, the real interest rate becomes zero or negative, and the borrower benefits from inflation while the lender suffers losses.