Write short answers to the questions below. 16. A one-year discount bond has a f

Question

Write short answers to the questions below. 16. A one-year discount bond has a face value of $100 and a market price of $98. The current inflation rate is 1%. a. Calculate the real interest rate on the bond. Round off at the first place after the decimal. b. Now suppose that the inflation rate is expected to rise to 3%. As a result the demand and the supply of the bond shift. These shifts however do not cause the real interest rate to change under the new equilibrium. Calculate the new equilibrium price of the bond. Round off at the second place after the decimal.

Explanation / Answer

Equation will be

100=98(1+i)

So i will be 2.041%

Real interest rate will be 1.02041/1.01 =1.031%

b) Now if inflation rises to 3%,

Nominal rate = 1.03*1.010306=4.062%

So the price will be 100/1.04062=$96.097

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