How does an unanticipated decline in the price level cause a drop in lending?

• A. It increases the real value of borrowers' debts, making it harder for them to repay loans and discouraging banks from lending.
• B. It increases consumer confidence, leading to higher demand for loans.
• C. It reduces the nominal interest rate, encouraging more borrowing and lending.
• D. It decreases the real value of collateral, making lending more attractive to banks.

Answer: (A)

Verified step by step guidance

1. Step 1: Understand the relationship between the price level and the real value of debt. When the price level falls unexpectedly, the real value of money increases because each unit of currency can now buy more goods and services.
2. Step 2: Recognize that borrowers have debts fixed in nominal terms. An unanticipated decline in the price level means the real burden of these debts rises, as borrowers must repay the same nominal amount with money that is now more valuable.
3. Step 3: Analyze the impact on borrowers' ability to repay loans. Since the real value of their debt increases, borrowers find it harder to repay, which raises the risk of default.
4. Step 4: Consider the banks' perspective. Higher default risk makes banks more cautious, reducing their willingness to lend because the expected returns on loans decrease and the risk of losses increases.
5. Step 5: Conclude that the unanticipated decline in the price level leads to a drop in lending primarily because it increases the real value of borrowers' debts, discouraging borrowing and making banks less willing to extend credit.