Question

1. Explain the difference between the expected real interest rate and the realized real interest rate. Which is more relevant to decision making? Why? Which is more relevant for determining whether a borrower or lender is better or worse off because of unexpectedly high or low inflation? Why?

2. You buy a one-year debt security on December 31, 2016, for $10,000, which will pay you a nominal interest rate of 5%. From December 31, 2016, to December 31, 2017, the inflation rate is 2%. You have a tax rate of 35%. Answer the following and show your calculations.

a) How much nominal interest do you earn during the year?

b) How much do you pay in taxes on your interest income?

c) How much is your after-tax nominal income?

d) How much principal do you lose because of inflation?

e) How much real interest income do you earn?

f) How much is your after-tax real interest income?

g) What percent of your nominal interest income goes to:

(1) you, in the form of after-tax real interest income

(2) the government, in the form of taxes

(3) inflation, in the form of lost principal value

Answer 1

Ans 1: Expected Real interest rate is nothing but when the nominal interest rate is adjusted with expected inflation rates, then that adjusted nominal interest rates actually becomes Expected real interest rates, on the other hand, when the nominal interest rate is adjusted with actual inflation rates then that nominal interest rates actually becomes realized interest rates.

I would rather say that Expected real interest is more relevant for decision making because investor has to invest before any one is getting to know the real inflation rates, hence he can you expected real interest rates based on expected inflation rates thus he can invest before head. Hence expected real interest rate is more relevant for decision making.

Realized Real interest rate is more  relevant for determining whether a borrower or lender is better or worse off because low inflation hurts lenders and helps borrower and vice versa. Hence I would rather say that realized real rate shows actual inflation and then investors can take the decision based on inflation movement.