Question

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

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?

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Homework Answers

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%.

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