As a bank loan officer, you are now in charge of setting interest rates for short...

As a bank loan officer, you are now in charge of setting interest rates for short term loans. A customer comes in asking for a $10,000 loan for 1 year. As a bank, you will not offer a loan in which your real return on investment is at least 3%. You also know the FED is setting its inflation goal for this year at 2%. Assuming you trust the FED will meet its stated goal, what is the minimum nominal interest rate you can charge for this loan?

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$500

300

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Expert Solution

Answer) 5%

Explanation: The Fisher Effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation. It is given that real return on investment is atleast 3% and inflation set for the year is 2%, therefore, nominal interest rate = real interest rate + inflation. Thus, minimum nominal interest rate is 5% (3% + 2%).

Rahul Sunny answered 1 year ago

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