Question

For each of the following years, determine the real interest rate. Find the difference between this rate and the desired real interest rate and explain how any difference affects borrowers and lenders. Write out percentage rates as whole numbers e.g. 5%.

a. In year 1, the nominal interest rate is 5%, the inflation premium on loans is 3%, and actual rate of inflation is 4%.

The real interest rate is  %, the desired real interest is  %, borrowers are  (Click to select)  better off  unaffected  worse off  and lenders are  (Click to select)  better off  unaffected  worse off  .

b. In year 2, the nominal interest rate is 6%, the inflation premium is 4%, and the actual rate of inflation is 2%.

The real interest rate is  %, the desired real interest is  %, borrowers are  (Click to select)  better off  unaffected  worse off  and lenders are  (Click to select)  better off  unaffected  worse off  .

c. In year 3, the nominal interest rate is 4%, the inflation premium is 2%, and the actual rate of inflation is 2%.

The real interest rate is  %, the desired real interest is  %, borrowers are  (Click to select)  better off  unaffected  worse off  and lenders are  (Click to select)  better off  unaffected  worse off  .

Answer 1

Working notes:

• Actual real rate = Nominal rate - Actual inflation rate
• Desired real rate = Nominal rate - Desired inflation rate, and
• If Actual inflation is higher (lower) then Expected inflation, borrowers are better (worse) off and lenders are worse (better) off.

(a) Actual inflation = 4%, Expected inflation = 3% and Nominal rate = 5%

The real interest rate is (5 - 4) = 1%, the desired real interest is (5 - 3) = 2%, borrowers are better off and lenders are worse off.

(b) Actual inflation = 2%, Expected inflation = 4% and Nominal rate = 6%

The real interest rate is (6 - 2) = 4%, the desired real interest is (6 - 4) = 2%, borrowers are worse off and lenders are better off.

(c) Actual inflation = 2%, Expected inflation = 2% and Nominal rate = 4%

The real interest rate is (4 - 2) = 2%, the desired real interest is (4 - 2) = 2%, borrowers are unaffected and lenders are unaffected.