Question

Assume inflation is 2.60% and the nominal (annual) interest rate is 6.35%. If the interest rate is held constant, but inflation rises to 5.25%, does it cost more or less in real terms to borrow money than when the inflation rate was 2.60%? Explain your answer and make sure to include your real interest rates in both situations to earn full credit.

Answer 1

The real interest rate when inflation is 2.6%,

(1 + nominal rates) = (1 + real rate) * (1 + inflation),

(1 + nominal rate of interest)/(1 + inflation) = ( 1 + real rate of interest)

(1.0635)/1.026 - 1 * 100

so, the real rate of interest is = 3.65%

Now, when the inflation rate is 5.25%,the nominal rate of interest is 6.35%,

the real rate of interest is 1.045%

As, the inflation rate increases, the borrower benefits as the real rate of interest after accounting for inflation decreases as the rate of inflation increases. If the inflation increases, the real interest rate falls.