Question

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7. Calculating Real Rates of Return If Treasury bills are currently paying 4.5 percent and the inflation rate is 2.1 percent, what is the approximate real rate of interest? The exact real rate?

 8. Inflation and Nominal Returns Suppose the real rate is 2.4 percent and the inflation rate is 3.1 percent. What rate would you expect to see on a Treasury bill?

 9. Nominal and Real Returns An investment offers a 14 percent total return over the coming year. Alan Wingspan thinks the total real return on this investment will be only 10 percent. What does Alan believe the inflation rate will be over the next year?

 10. Nominal versus Real Returns Say you own an asset that had a total return last year of 12.5 percent. If the inflation rate last year was 5.3 percent, what was your real return?

Answer 1

The approximate relationship between nominal interest rates (R), real interest rates (r), and inflation (h) is:

R = r + h

Approximate r = .045 –.021 =.024 or 2.40%

The Fisher equation, which shows the exact relationship between nominal interest rates, real interest rates, and inflation is:

(1 + R) = (1 + r)(1 + h)

(1 + .045) = (1 + r)(1 + .021)

Exact r = [(1 + .045) / (1 + .021)] – 1 = .0235 or 2.35%