10. A neighbor stops by to discuss her latest business scheme. She is hoping to

Question

10. A neighbor stops by to discuss her latest business scheme. She is hoping to start a rabbit farm in her backyard, but needs start-up capital. She is asking you for a one-year loan of $3,000 to get started. You have no doubt she will pay you back (with interest), but you still need to determine an interest rate to charge her. Assume you believe the rate of inflation will be 4.5 percent over the year. You are willing to forego the use of the $3,000 as long as, when returned, you can purchase 5 percent more goods and services.

A. Given the above, determine the nominal interest rate you would charge your neighbor. Explain how you determined that value.
B. Assume inflation during this time period is lower than anticipated, only 2.5 percent. Who benefited from inflation being lower than anticipated? Who was hurt? Explain. In you explanation, use the concepts of the expected and actual real interest rate.

10) A neighbor stops by to discuss her latest business scheme. She is hoping to start a rabbit farm in her backyard, t needs start-up capital. She is asking you for a one-year loan of $3,000 to get started. You have no doubt she will pay you back (with interest), but you still need to determine an interest rate to charge her. Assume you believe the rate of inflation will be 4.5 percent over the year. You are willing to forego the use of the $3000 as long as, when returned, you can purchase 5 percent more goods and services. A. Given the above, determine the nominal interest rate you would charge your neighbor. Explain how you determined that value. Who benefited from B. Assume inflation during this time period is lower than anticipated, only 2.5 percent. inflation being lower than anticipated? Who was hurt? Explain. In you explanation, use the concepts of the expected and actual real interest rate.

Explanation / Answer

10. A. Given the above, A neighbor is asking you for a one-year loan of $3,000 to get started. You believe the rate of inflation will be 4.5 percent over the year and you want to have enough to be returned so as to purchase 5 percent more goods and services. This implies you want a real interest rate of 5% and so adding the value of price rise, the expected inflation rate, we will charge a nominal rate of 4.5% + 5% = 9.5%. The expected real interest rate at this level is therefore 5%.

B. Assume inflation during this time period is lower than anticipated, only 2.5 percent. Because inflation was less than expected, and so actual real interest rate is now 9 - 2.5% = 6.5%. So you have benefited from inflation being lower than anticipated because you receive a greater rate of return in real terms. You expected it to be 5% more but it is 6.5% more. In that sense, the neighbour is hurt because he pays a higher real interest rate.

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