Question

Suppose that the nominal rate of interest is 5% and the expected rate of inflation is 2%. Whats is the expected real rate of interest according to Fisher? Calculate the after-tax expected real rate of assuming a 30% marginal tax rate. If inflation expectations increase by 2%, what will be the new nominal rate according to fisher? According to darby/feldstein? What should happen to bond prices and stock prices if the expected rate of inflation increase

Answer 1

According to the Fisher effect, the relationship between the nominal interest rate, r, the real interest rate a, and the expected inflation rate, i, is 1 + r = (1 + a)(1 + i).

Substituting in the numbers in the problem yields 1 + r = 1.05/1.02 = 1.0294, or r = 2.94%.

The after tax expected real rate = 2.94%*(1 - 0.30) = 2.06%

If inflation increase by 2%, new inflation be 2% + 2% = 4%

1 + r = (1.0206) (1.04)

r = 6.14%

If there is increase in expected inflation, bond prices will rise and stock prices will fall.