Question

Over the next year, the real interest rate is 2% and the expected inflation rate is 5%.

A. What is the nominal interest rate on a one-year loan?

B. Assume that the actual inflation rate turns out to be 3%, instead of 5%. • Who benefits, the lender or the borrower? • What is the realized real interest rate on this loan?

Answer #1

(A)

Real interest rate = 2%

Expected inflation rate = 5%

Calculate the nominal interest rate -

Nominal interest rate = Real interest rate + Expected inflation rate = 2% + 5% = 7%

Thus,

**The nominal interest rate on
a one-year loan is 7%.**

(B)

The actual inflation rate turns out to be 3%, instead of 5%.

When actual inflation rate is less than the expected inflation rate then realized real interest rate is greater than the expected real interest rate.

This means that lender get higher real return than expected while borrower pays higher real return than expected.

So,

**The lender
benefits.**

Calculate the realized real interest rate -

Realized real interest rate = Nominal interest rate - Actual inflation rate = 7% - 3% = 4%

**The realized real interest
rate is 4%.**

Suppose that a borrower and a lender agree on the nominal
interest rate to be paid on a loan. Then inflation turns out to be
lower than they both expected.
(1) True or False: The real interest rate on
this loan is lower than expected.
The lender (2) gains/loses from this unexpected
lower inflation, and the borrower
(3) gains/loses under these circumstances.
Inflation during the 1970s was much higher than most people had
expected when the decade began.
Homeowners who...

When the actual inflation rate turns out to be greater than the
expected inflation rate, who gains—the borrower or the lender—and
who loses? Explain why.

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.

If the real interest rate was large during the last year, then
a. inflation is expected to exceed the nominal interest rate in the
future. b. inflation is expected to be less than the nominal
interest rate in the future. c. actual inflation was less than the
nominal interest rate. d. actual inflation was greater than the
nominal interest rate.

You expect inflation over the next year to be -2.5%. Actual
inflation over the last year was 2.59%, and the current nominal
interest rate is 6.3%. What is your expected real rate of interest
(in %)? Round to 0.01%. E.g., if your answer is 3.145%, record it
as 3.15.

The real risk-free rate of interest is 2%. Inflation is expected
to be 3.5% the next 2 years and 6% during the next 3 years after
that. Assume that the maturity risk premium is zero. What is the
yield on 3-year Treasury securities? What is the yield on 5-year
Treasury securities?
PLEASE SHOW WORK, EXPLANATION, AND EQUATION

Suppose the underlying real interest rate is 4%. People expect
an inflation rate of 2.3% over the next year.
a) At what rate will banks set their interest rates?
b) Suppose inflation turns out to be 3%. Using your answer from
(a), what does the real interest rate turn out to be?
c) Explain why unexpectedly high inflation helps borrowers

Boris Borrower and Lynn Lender agree that Lynn will lend Boris
$10,000 and that Boris will repay the $10,000 with interest in one
year. They agree to a nominal interest rate of 8%, reflecting a
real interest rate of 3% on the loan and a commonly shared expected
inflation rate of 5% over the next year.
Assume that there is a fall of 2 percentage points in the
expected future inflation rate. How will the real interest
rate be affected...

If the interest rate on a loan is fixed at 6% over the course of
10 years, and the rate of inflation is currently 2.5%, which of the
following is NOT true?
the real interest rate is less than the nominal interest
rate
the borrower bears the risk of higher inflation
the lender bears the risk of higher inflation
the nominal interest rate is 6% the real interest rate is
3.5%

What is the value of the real interest rate in each of the
following situations?
The nominal interest rate is 15%, and the expected inflation
rate is 13%.
The nominal interest rate is 12%, and the expected inflation
rate is 9%.
The nominal interest rate is 10%, and the expected inflation
rate is 9%.
The nominal interest rate is 5%, and the expected
inflation rate is 1%.
In which of the above situations would you prefer to be the
lender?...

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