turt1e , 11 months ago (edited 11 months ago)

I was having trouble wrapping my head around this at first but if the example below is correct I think I get it now.

Suppose you borrow $10,000 from a lender at an interest rate of 5% per year, and you have to repay the loan in one year. Now, let’s assume that there is an inflation rate of 3% during that year.

Without inflation:

Loan amount: $10,000
Annual interest rate: 5%.
Interest payment: $10,000 * 5% = $500.
Total repayment: $10,000 (loan amount) + $500. (interest payment) = $10,500.

With inflation:

Loan amount: $10,000
Annual interest rate: 5%.
Inflation rate: 3%.
Interest payment: $10,000 * 5% = $500.
Total repayment adjusted for inflation: $10,000 (loan amount) + $500 (interest payment) = $10,500.
Inflation-adjusted value of repayment: $10,500 / (1 + 3%) = $10,145.63.

In this example, the inflation rate of 3% effectively reduced the real value of the debt repayment to $10,145.63, making it cheaper in real terms. This is because the value of money decreased due to inflation, allowing you to repay the debt with dollars that have a lower purchasing power.`