Question

Suppose the nominal annual interest rate on a two-year loan is 8 percent and lenders expect inflation to be 5 percent in each of the two years. The annual real rate of interest is:______.
A. 6 percent.
B. 8 percent
C. 2 percent.
D. 3 percent.

Answer 1

Answer:

C. 2 percent.

Explanation:

The computation of the annual real rate of interest is presented below:

Provided that

Nominal annual interest rate = 8%

Inflation rate = 5%

So, the annual real rate of interest is

Real rate of return = {( 1 + nominal annual rate of return) ÷ ( 1 + inflation rate)} - 1

= {( 1 + 0.08) ÷ ( 1 + 0.05)} - 1

= 2%