Joe borrowed $300 from his friend Mike to buy a $300 bike. Joe agreed to pay Mike 5% interest rate to compensate him for not having use of his $300 for that year and to adjust for the 2% inflation in the past. That nominal interest rate would imply a 3% real interest rate on the loan. Suppose that over the year the inflation rate was 3%, rather than 2% rate Joe and Mike had expected. Who gains and who loses? How would your answer differ if the actual inflation rate over the year was 1%?

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