Suppose you borrow $100 of principal that must be repaid at the end of two years, along with interest of 5 percent a year. If the annual i n flation rate turns out to be 10 percent, ( a ) What is the real rate of interest on the loan? ( b ) What is the real value of the principal repayment? ( c ) Who loses, (A) the debtor (B) or the creditor? (Enter A or B.)
The compounded value of $100 at the end of 2 years will be 100*105%*105% = $110.25
But inflation reduces the real value of money so the real equivalent of $110.25 will be = 110.25/110%/110% = 91.115
a) Hence for $100 borrowed today , You pay 91.115 in real terms after 2 years.
The real rate of interest is [1 - sqrt(91.115/100)] = -4.545% i.e negative 4.54%
b) The real value of principal repayment is $91.115
c) Loser is the creditor (B)