You are given a loan with a nominal interest rate of 5%. You must pay back...

You are given a loan with a nominal interest rate of 5%. You must pay back this loan one year from now. Over the next year inflation is at 4%. In real terms what is the effective interest rate you must pay the loan back at after adjusting for inflation?

Solutions

Expert Solution

To calculate the effective interest rate in real terms we must know the Fisher equation. The Fisher equation states that the nominal interest rate is the sum of real interest rate and inflation rate. The implication is that as inflation rate rises then the dollar value of money decreases and so real interest rate is lower.

Given - NIR = 5%

Inflation rate = 4%

From Fisher equation, NIR = Real Interest rate + Inflation rate

So RIR = NIR-IR = 5%-4% = 1%

Hence the effective interest rate in real terms is 1%

This implies that as inflation exists, less is the real effective interest rate than the nominal interest rate.

Rahul Sunny answered 1 year ago

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