Question

PART I: Numerical Exercises. You must show your work and label all graphs carefully and legibly. Not showing your work will get you zero points on the question, even if your answer is correct. (26 points)

1. a.   Assume the nominal interest rate is 17 percent and the expected rate of inflation is

12 percent. Calculate real rate of interest.

b.   Now assume instead that the nominal interest rate is 4 percent and the expected rate of

      inflation is minus 1 percent. Calculate the real rate of interest.

c. Assume the expected rate of inflation is 3 percent per year. What nominal interest rate

      should you charge to receive a real interest rate of 2 percent per year?

Answer 1

Part 1

(a)

Nominal interest rate = 17 percent

Expected rate of inflation = 12 percent

Calculate the real rate of interest -

Real rate of interest = Nominal interest rate - Expected rate of inflation

Real rate of interest = 17% - 12% = 5%

Thus,

The real rate of interest is 5 percent.

(b)

Nominal interest rate = 4 percent

Expected rate of inflation = -1 percent

Calculate the real rate of interest -

Real rate of interest = Nominal interest rate - Expected rate of inflation

Real rate of interest = 4% - (-1%) = 4% + 1% = 5%

Thus,

The real rate of interest is 5 percent.

(c)

Expected rate of inflation = 3 percent

Desired real interest rate = 2 percent

Calculate the nominal interest rate -

Nominal interest rate = Expected rate of inflation + Desired real interest rate

Nominal interest rate = 3% + 2% = 5%

Thus,

The nominal interest rate that should be charged is 5 percent.