Economists forecast the following inflation rates for the next four years What inflation adjustment should be included in the interest rate on a four-year loan made today?

A) 3%, because that's the rate at the time the loan is made and borrowers won't pay any more
B) 6%, because that's the rate that will exist when the loan is repaid and the lender can loan the money out again
C) 4.5%, because that's the average expected inflation rate over the life of the loan
D) at least 7%, because the lender needs to protect itself from unexpectedly high inflation rates

Question

Economists forecast the following inflation rates for the next four years

What inflation adjustment should be included in the interest rate on a four-year loan made today?

A) 3%, because that's the rate at the time the loan is made and borrowers won't pay any more
B) 6%, because that's the rate that will exist when the loan is repaid and the lender can loan the money out again
C) 4.5%, because that's the average expected inflation rate over the life of the loan
D) at least 7%, because the lender needs to protect itself from unexpectedly high inflation rates

Vishal Navle · Accepted Answer

Final Answer : C, Explanation :  The inflation adjustment included in the interest rate on a four-year loan made today should be the average expected inflation rate over the life of the loan, which is 4.5%. Option A is incorrect because borrowers will still have to pay the inflation rate that is expected during the loan period. Option B is incorrect because it assumes that the lender can always lend out the money again at the same interest rate, which may not be the case. Option D is incorrect because it assumes the inflation rate will be higher than the forecasted average, and does not provide a specific reason for choosing 7%.

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