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Question 5 In the morning of December 31st , Eddy goes to his local bank to...

Question 5 In the morning of December 31st , Eddy goes to his local bank to borrow $10,000, to be repaid in one year. The bank loans officer tells Eddy the nominal rate the bank will charge him is 6%. This rate is determined taking into account the bank expects inflation for the year that will start on January 1st to be 3%, because that is the bank’s forecast.

a) What is the real interest rate that Eddy will pay in one year? Explain briefly. b) If inflation over the term of this loan turns out to be higher than the bank forecasted, will Eddy be hurt or will the bank be hurt? Explain briefly your answer. c) If inflation over the term of this loan turns out to be lower than the bank forecasted, will Eddy be hurt or will the bank be hurt? Explain briefly your answer.

Expert Solution

Question 5

(a)

Real interest rate is the difference between the nominal interest rate and the expected inflation rate.

Nominal interest rate = 6%

Expected inflation rate = 3%

Calculate the real interest rate -

Real interest rate = Nominal interest rate - Expected inflation rate

Real interest rate = 6% - 3% = 3%

Thus,

The real interest rate that Eddy will pay in one year is 3%.

(b)

If inflation rate over the term of this loan turns out to be higher than the bank forecasted then in that case realized real interest rate would be lower than the expected real interest rate.

This means that bank will get lower real interest rate than it anticipated.

So,

The bank will be hurt.

(c)

If inflation rate over the term of this loan turns out to be lower than the bank forecasted then in that case realized real interest rate would be higher than the expected real interest rate.

This means that Eddy will be paying higher real interest rate than he anticipated.

So,

Eddy will be hurt.

Rahul Sunny answered 2 years ago

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