Interest Rate, Inflation, Money Market

2 Real vs Nominal Interest Rates
1. Tywin knows he has a debt to repay soon. The bank charges him an interest rate of
6%, percent. If the expected rate of inflation is 5%, how much interest is he effectively
paying? Explain.
2. Calculate the nominal rate of inflation that will be charged if the expected rate of
inflation is 7%, and the real return desired is 5%. Show all work.
3. If the rate of inflation is 3% instead, what happens to the value of the money paid
back? Explain.
i = r + infe = 7% + 5% = 12%
If the actual rate of inflation turns out to be 3%, then the real interest earned from a
nominal interest rate of 12% is:
r = i − inf = 12% − 3% = 9%
In this case, because the inflation was lower than expected, the real amount paid back
(9%) is higher than the real amount that was anticipated (7%). Lenders benefits from this
unanticipated disinflation and borrowers are hurt.
4. The real interest rate paid on an asset was 10%, but the nominal rate was 9%. What
was the rate of inflation?