Question

(a) James is applying for a new home loan. He wishes to borrow $250,000 and make his repayments monthly. The interest rate the bank has quoted him is 4% per annum. 1. Is this the real rate of interest or the notional rate of interest? 2. Explain the difference between the real rate of interest and the notional of interest. 3. Calculate the real rate of interest and the notional rate of interest for James. 4. Is it possible for the real rate of interest to equal the notional rate of interest? Explain.    (b) The Reserve Bank of Australia has announced a 0.25% decrease in the cash rate. What effects does this have on the economy and the financial markets? Provide examples of who might benefit from this decrease and those that do not.

Answer 1

1]

This is the notional rate of interest. Bank loan rates are quoted in notional interest rates, and not in real interest rates

2]

The real rate of interest is the notional rate of interest, adjusted for inflation. Roughly, real rate = notional rate - inflation.

The nominal rate calculates the actual dollar value of interest, whereas the real rate calculates the actual purchasing power of the nominal dollar value

3]

The inflation rate is not given. Let us assume that inflation is 1.5%

Then, real rate = notional rate - inflation = 4% - 1.5% = 2.5%

4]

The real rate will equal the nominal rate only when inflation equals zero