Suppose that there is compound interest at an annual inflation adjusted rate of 1.8% and that...

Suppose that there is compound interest at an annual inflation adjusted rate of 1.8% and that the annual rate of inflation is 2.3%. Find the force of interest corresponding to the stated rate of interest and the inflation-adjusted force of interest corresponding to the real rate of interest. In general, what can you say about the difference between the force of interest and the inflation-adjusted force of interest?

Expert Solution

Force of Interest:

Force of interest refers to a nominal interest rate compounded infinite number of times per time period.

The Compound interest rate at an annual adjusted inflation rate is 1.8%

Inflation rate is 2.3%

The compound interest rate before adjusting inflation rate is 4.1%

Calculation of Force of Interest:

The force of interest is calculated by:

Force of interest δ = 1n ( 1+i )

Force of interest δ = 1n ( 1+0.041) = 4.02%

Inflation adjusted Force of Interest:

Force of interest δ = 1n ( 1+i )

Inflation adjusted Force of interest δ = 1n ( 1+0.018) = 1.78%

Difference between the force of interest and the inflation-adjusted force of interest:

The force of interest represents the nominal force of interest and inflation-adjusted force of interest shows us the real force of interest. A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor.

ekkarill92 answered 2 years ago

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