Question

For 1,000 bags of cement from your friend, you promise to return 1,100 bags in one year.
i. What is the expected real return % to your friend?
ii. You actually did not borrow 1,000 bags of cement from your friend, since she does not deal in cement. Instead, you borrowed enough cash from her to buy 1,000 bags of cement at GH¢ 38 each. If you pay her back enough GH¢ to buy 1,100 bags of cement that you promised but cement prices have gone up by 20%, what is her nominal return %?
iii. Show that Fisher Effect holds.

Answer 1

i. Expected return would be= ((1100-1000)/1000)*100 = (100/1000)*100 = 0.1*100 =10%

ii. Cost of 1000 bags= 38,000

increase in price of cement= 38 + (38*20%)= 38+7.6 = 45.6

Cost of returning of bags after a year= 45.6*1100= 50,160

Nominal rate of return= ((50,160-38000)/50,160)*100 = (12160/50160)*100 = 0.32*100= 32%

So, from this we can conclude that 32% is the nominal rate of return after one year.

iii. Fisher effect

Real interest rate= nominal rate - inflation rate = 32%- 20% =12%