When people take out a loan, they pay a nominal interest rate. Likewise, bond yi

Question

When people take out a loan, they pay a nominal interest rate. Likewise, bond yields are quoted in nominal terms. The nominal interest rate times the loan amount equals the dollar amount the borrower must pay in interest. The expected real interest rate times the loan amount measures the expected purchasing power of these dollars. Unexpected changes in the inflation rate affect borrowers and lenders. Suppose that a bank offers a loan with a nominal interest rate of 10% and the expected inflation rate in the economy equals 3%. The terms of the loan are not renegotiated, so the borrower has a guaranteed nominal interest rate of 10%. What is the expected real interest rate for this loan?

Explanation / Answer

R=NOMINAL INTERST RATE=10% r= real INTERST RATE=? i=expected inflation rate=3% (1+r) (1+i)=(1+R) (1+r)(1+0.03)=(1+0.1) R=6.79%

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