Question

Suppose Sally borrows $1,000 from Harry for one year and agrees to pay a nominal interest rate of 8%. When she borrows the money, both she and Harry expect an inflation rate of 6%.
1. The expected real interest rate on the loan is_______%.
2. Suppose that when Sally pays back the loan after one year, the actual inflation rate turns out to be 4%. The actual real interest rate on the loan is______%.
3A. If the inflation rate turned out to be higher than expected, then_______.
3B. But if inflation turned out to be lower than expected, then_______.

Answer 1

Answer:

1.  1,89%

2. 3,85%

3A. A Lower real rate will be obtained, and Harry is in worse off position

3A. A Higher real rate will be obtained, and Harry is in better off position

Explanation:

Real Interest Rate is the Nominal Return that has been adjusted with the Inflation rate.

The effect of the inflation is to reduce the value of money over time.

If Inflation rate was 6%

Real Interest Rate = ( 1 + nominal return) / (1 + Inflation rate) - 1

                              = ( 1 + 0.08) / ( 1 + 0.06) - 1

                              = 0.0189 or 1,89%

If Inflation rate was 4%

Real Interest Rate = ( 1 + nominal return) / (1 + Inflation rate) - 1

                              = ( 1 + 0.08) / ( 1 + 0.04) - 1

                              = 0.0385 or 3,85%