Suppose I lend my friend Peter $100 for one year, and he agrees to repay me with interest. We each have an expectation that the inflation rate over the coming year will be 5 percent, and so we agree...

Suppose I lend my friend Peter $100 for one year, and he agrees to repay me with

interest. We each have an expectation that the inflation rate over the coming year

will be 5 percent, and so we agree that he will pay me back at a nominal rate of 7

percent interest.

a) What real rate of return do I expect to receive?

b) What happens if inflation turns out to be 8 percent over the year? Who is

made better off and who is made worse off?

c) What happens if inflation turns out to be 3 percent over the year? Who is

made better off and who is made worse off?