Unexpected Low Inflation Raises Real Interest Rates

Steps:

• Nominal interest rates are set based on expected inflation to maintain desired real rates.
• If actual inflation is lower than expected, real interest rates (nominal minus actual inflation) exceed expectations.
• Lenders gain from higher real returns on loans.
• Borrowers face higher real repayment costs, increasing their burden.

Why B is correct:

• Real interest rate formula (real rate = nominal rate - inflation rate) shows lower inflation boosts real rates, benefiting lenders with higher purchasing power returns while harming borrowers with costlier real debt service.

Why the others are wrong:

• A: Borrowers are harmed, not benefited, by higher real costs.
• C: Lenders are benefited, not harmed, by higher real returns.
• D: Effects are asymmetric; lenders gain while borrowers lose.

Final answer: B