Question

1. Suppose you borrow money at a nominal interest rate of 14%. At the time you borrow the money, you expect inflation to be 8%. The real interest rate you expect to pay on your loan is______%.
2. Suppose that when you pay back the loan, inflation turned out to be 9%. The real interest rate you actually pay back is_______.
3. Suppose that when you pay back the loan, inflation turned out to be 5%. The real interest rate you actually pay back is______.
4. Think about the case where inflation turned out to be higher than expected. You initially thought inflation was going to be 3%, but it turned out to be 9%. Since the inflation rate turned out to be higher than______expected, then than you both expected.

Answer 1

Answer:

1) 6% , 2) 5% , 3) As inflation rate ise higher than expected inflation rate, real interest rate would be lower than expected real interest rate

Explanation:

Real Interest Rate is the interest rate, which accounts for the impact of inflation.

Real Interest Rate = Nominal Interest Rate - Inflation

1) 14% - 8% = 6%

2) 14% - 9% = 5%

3) In case of variation in expected & actual inflation rate

1 + nominal interest rate = (1 + real interest rate) (1 + expected inflation rate)

1 + 14% = (1 + r) (1 + 3%)

1.14 = (1 + r) (1.03)

1.14 = 1.03 + 1.03r

0.11 = 1.03r

r = 8.82  {If inflation is higher at 9%}

If inflation could have been at expected 3%, real interest rate could have been 14% - 3% = 11%.

So : As inflation rate turned out to be higher than expected inflation rate, real interest rate turned out to be lower than expected real interest rate