Question

Given the nominal interest rate of 13​% and the expected inflation of 15​%, then the value of the real interest rate is ___ ?

2. With the real interest rate equal to 3​% and the expected inflation equal to 2​%, then the value of the nominal interest rate is___?

3. A lender prefers a (high or lower) real interest rate while a borrower prefers a (higher or lower) real interest rate higher lowreal interest rate.

Answer 1

1. Real interest rate = [(1 + nominal interest rate)/ (1 + expected rate of inflation)] - 1 = (1.13/1.15) - 1

= -0.01739 i.e. -1.74%

or simply Real interest rate = nominal interest rate - expected rate of inflation = 13%-15% = -2%

2. Nominal interest rate = Real interest rate + Expected inflation = 3% + 2% = 5%

3. A lender prefers a (lower) real interest rate while a borrower prefers a (higher) real interest rate.

The concept of the real interest rate is why lenders prefer to lend funds at interest rates that vary with the current market interest rate - this allows them to avoid the risk of lending at an excessively low real interest rate.