Question

Homer and Barney only consume Duff. One week Homer finds he has no money to buy any Duff and so asks Barney for a loan to purchase his weekly consumption of 25 bottles. Barney - being a good friend – and noting that the price of a bottle of Duff at the beginning of the week is $4, offers to lend Homer $100 at a weekly interest rate of 1%.

If Homer takes the loan from Barney and the price of a bottle of Duff increases by 10 cents during the week, what is the (approximate) ex-post weekly real interest rate that Homer will pay?

Answer 1

Barney has made the loan to Homer at weekly interest rate of 1%.

The price of a bottle of Duff is $4.

The price of bottle increases by 10 cents or $0.10 during the week.

Calculate the inflation rate -

Inflation rate = (Increase in price/initial price) * 100

Inflation rate = ($0.10/$4) * 100

Inflation rate = 2.5%

Calculate the real interest rate -

Real interest rate = Nominal interest rate - Inflation rate

Real interest rate = 1% - 2.5% = -1.5%

Thus,

The (approximate) ex-post weekly real interest rate that Homer will pay is -1.5%.