Question

Suppose banks decided to charge a 17% interest rate, assuming an expected inflation rate of 5%. However, they ended up charging an interest rate of 14%, with a real interest rate of 7%. Which of the following statements holds true for the given scenario? a Banks benefited, due to an unanticipated inflation of 2%. b Banks benefited, due to an unanticipated inflation of 9%. c Banks benefited, due to an unanticipated inflation of 12%.

d Banks faced losses, due to an unanticipated inflation of 7%. e Banks faced losses, due to an unanticipated inflation of 5%.

Answer 1

Banks faced losses due to an actual inflation rate that was lower than expected, which resulted in a lower real interest rate than they had planned for, leading to a decrease in the real value of the money repaid to them.

Step-by-step explanation:

The question concerns the effect of real interest rates and inflation on banks. When a bank charges a nominal interest rate of 14%, with an expected inflation rate of 5%, but the actual real interest rate turns out to be 7%, this implies that the actual inflation rate was 7% (14% nominal rate - 7% real rate). Contrast this with the expected 17% nominal interest rate initially planned, assuming an expected inflation rate of 5%. The correct statement is that banks faced losses due to unanticipated inflation being lower than expected. Instead of the expected 5% inflation rate (which would have resulted in a 12% real interest rate with the planned 17% nominal rate), the actual inflation rate paired with the 14% nominal rate resulted in a 7% real interest rate.

Since the real interest rate is 7%, not the expected 12%, banks received less in real terms than they planned. There was no unanticipated inflation. Instead, the banks suffered losses because the real value of the money they loaned out is less than what they expected due to the lower actual inflation rate.

Answer 2

The banks suffered losses because the actual inflation rate was 7%, higher than the expected 5%. Thus, they charged a lower nominal interest rate than anticipated.

Step-by-step explanation:

When calculating the impact of inflation on interest rates, we must consider the real interest rate which is the nominal interest rate minus the rate of inflation. In the given scenario, the banks charged a 14% nominal interest rate, and experienced a real interest rate of 7%. This means that the actual inflation rate was 14% - 7% = 7%. The banks expected an inflation rate of 5%. Therefore, the unanticipated inflation rate was 7% - 5% = 2%. Considering this, the correct statement is: 'Banks faced losses, due to an unanticipated inflation of 7%'. This scenario illustrates that the banks' expected interest rate was surpassed by actual inflation, leading to losses instead of benefits.