Question

If inflation rises unexpectedly by \(5 \%,\) would a state government that had recently borrowed money to pay for a new highway benefit or lose?

Short answer

In this scenario, if inflation unexpectedly rises by 5%, a state government that recently borrowed money to pay for a new highway would likely benefit. They would be able to repay their loan with currency that has less purchasing power, or "cheaper" money. Even though interest rates may rise as a result of the inflation increase, the impact on the existing loan would likely be minimal since the state government has already secured the loan at a fixed interest rate.

Step-by-step solution

Understand Inflation and Borrowing

Inflation is the rate at which the general price level of goods and services in an economy is increasing over time. When prices are increasing, it means the purchasing power of money is decreasing. In other words, each currency unit buys fewer goods and services than it used to. This relationship between inflation and purchasing power is essential to understand its effect on borrowing. When the state government borrows money, it typically repays those loans over time, with interest. If the inflation rate is higher than anticipated, the real value (or purchasing power) of the money the government repays will be less than initially expected, because the money they borrowed will be worth less. This could either benefit or harm the government, depending on their financial situation and the impact on interest rates.

Evaluate the Benefits for the Borrower

If inflation rises unexpectedly, borrowers, in this case, the state government, may benefit from this situation. The borrowed amount remains the same in nominal terms but loses purchasing power over time due to inflation. When the government repays that money, it'll be doing so with "cheaper" currency, as their purchasing power has decreased. This essentially means the government is paying back less in real terms, as the higher inflation rate reduces the actual burden of the debt. The government benefits from this situation, as they can repay their loans with currency that is worth less than when they initially borrowed it.

Consider the Effects on Interest Rates

Interest rates and inflation are often closely tied together. As inflation increases, central banks may decide to raise interest rates to counteract inflationary pressures. If interest rates rise as a result of unexpected inflation, the cost of borrowing will also increase for the state government. This could potentially offset any benefit gained from repaying loans with less valuable currency due to the reduced purchasing power. However, it's essential to consider that the state government has already borrowed the money for the new highway, meaning the interest rate on that loan is likely fixed, and the rise in interest rates would not directly affect that specific loan. In conclusion:

Final Verdict

In this scenario, if inflation rises unexpectedly by 5%, a state government that recently borrowed money to pay for a new highway would most likely benefit. They would be able to repay their loan with currency that has less purchasing power or, in other words, "cheaper" money. Although interest rates may rise as a result of the inflation increase, the impact on the existing loan would likely be minimal since the state government has already secured the loan at a fixed interest rate.