Question

3. Distinction Between Real and Nominal Interest Rates

a. Distinguish between a nominal versus a real interest rate.

b. If a bond gives you a 4% nominal annual interest rate and the inflation rate over the year is 2%, what is the real ex post rate of return you receive? Real Rate You Receive _______________

c. If an investor wants a real rate of return of 2% and expects inflation to be 2% next year, what nominal rate should the investor demand? Nominal Rate Investor Demands _______________

Answer 1

The nominal rate of return includes the real rate and the inflation rate.It does not make adjustments to factor in the impact of inflation.It will not show the actual rate of borrowing or the actual rate of growth of the investment.the real rate on the other hand is adjusted for the inflation and thereby returns the actual rate of a borrowing or the actual rate of growth of an investment.

b.Real rate (exact figure )=1+nominal rate/1+inflation rate)-1=1+.04/1+.02)-1=.019608 that's 1.96%

or as an approximation 2%(4%-2%)(nominal rate-inflation rate)

c.If an investor wants a real return of 2% and expects inflation to be 2% the nominal rate should be Exact figure(1+real interest rate)+1+inflation rate)-1 that's (1+.02)*(1+.02)-1=0.0404 that's 4.04%(exact figure)

An approximate would be the real rate +inflation rate =2%+2% =4%