Answer to Question 1
The nominal interest rate includes a charge to compensate the lender for the loss in the purchasing power due to inflation. If inflation unexpectedly rises, the lender does not get compensated enough for the loss in purchasing power. Likewise the borrower pays too little to compensate the lender for inflation. So it is better to be a borrower in times of unexpected rising inflation.
When inflation unexpectedly falls, then the lender gets compensated too much for inflation. The borrower likewise pays too much for inflation. So it is better to be a lender rather than a borrower during a period of unexpected declining inflation.
Answer to Question 2
Return-chasing occurs when people invest in assets that have realized a high rate of return in the past. Return-chasing explains why many of Enron's employees chose to forgo the benefits of diversification and invested the overwhelming majority of their retirement savings in Enron stock. Enron stock had gone up by a factor of 10 in the decade before Enron went bankruptthat's a 1,000 percentreturn. This led Enron employees to mistakenly believe that Enron stock was a great investment for the future. Consequently, employees allocated more and more of their contributions to employer stock, under the assumption that Enron stock prices would continue to increase in the future.
A-head: EVIDENCE-BASED ECONOMICS: DO INVESTORS CHASE HISTORICAL RETURNS?
Concept: Return chasing
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