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INTEREST RATE, r (Percent) O Short-term interest rates O Long-term interest rates Which tend to be more volatile, short- or long-term interest rates? O O O O O 1.87% O 2.20% S2 CAPITAL (Billions of dollars) If the inflation rate was 3.40% and the nominal interest rate was 5.60% over the last year, what was the real rate of interest over the last year? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average. Round intermediate calculations to four decimal places. O 2.53% O 2.75% $1 + Equilibrium

INTEREST RATE, r (Percent) O Short-term interest rates O Long-term interest rates Which tend to be more volatile, short- or long-term interest rates? O O O O O 1.87% O 2.20% S2 CAPITAL (Billions of dollars) If the inflation rate was 3.40% and the nominal interest rate was 5.60% over the last year, what was the real rate of interest over the last year? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average. Round intermediate calculations to four decimal places. O 2.53% O 2.75% $1 + Equilibrium

ENGR.ECONOMIC ANALYSIS
ENGR.ECONOMIC ANALYSIS
14th Edition
ISBN:9780190931919
Author:NEWNAN
Publisher:NEWNAN
Chapter1: Making Economics Decisions
Section: Chapter Questions
Problem 1QTC
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Solve these 2 practice problems. Info for the 1. 

### Interest Rate and Capital Graph #### Graph Description: - **Axes:** - The horizontal axis represents **Capital (Billions of dollars)** ranging from 0 to 8. - The vertical axis represents the **Interest Rate (i.e., r) in percent**, ranging from 0 to 18. - **Lines:** - **Demand Line (D):** This line is depicted in blue, running diagonally from the top left to the bottom right. - **Supply Lines (S1 and S2):** - **Supply Line S1:** Shown in gray, moving diagonally from the bottom left to the top right. - **Supply Line S2:** Shown in orange, placed parallel to S1 but positioned slightly below it. - **Equilibrium Point:** Marked to the right of the graph, indicating where supply meets demand. --- #### Questions: 1. **Interest Rate Volatility:** Which tend to be more volatile, short- or long-term interest rates? - ○ Short-term interest rates - ○ Long-term interest rates 2. **Real Rate of Interest Calculation:** If the inflation rate was 3.40% and the nominal interest rate was 5.60% over the last year, what was the real rate of interest over the last year? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average. Round intermediate calculations to four decimal places. - ○ 1.87% - ○ 2.20% - ○ 2.53% - ○ 2.75%
Transcribed Image Text:### Interest Rate and Capital Graph #### Graph Description: - **Axes:** - The horizontal axis represents **Capital (Billions of dollars)** ranging from 0 to 8. - The vertical axis represents the **Interest Rate (i.e., r) in percent**, ranging from 0 to 18. - **Lines:** - **Demand Line (D):** This line is depicted in blue, running diagonally from the top left to the bottom right. - **Supply Lines (S1 and S2):** - **Supply Line S1:** Shown in gray, moving diagonally from the bottom left to the top right. - **Supply Line S2:** Shown in orange, placed parallel to S1 but positioned slightly below it. - **Equilibrium Point:** Marked to the right of the graph, indicating where supply meets demand. --- #### Questions: 1. **Interest Rate Volatility:** Which tend to be more volatile, short- or long-term interest rates? - ○ Short-term interest rates - ○ Long-term interest rates 2. **Real Rate of Interest Calculation:** If the inflation rate was 3.40% and the nominal interest rate was 5.60% over the last year, what was the real rate of interest over the last year? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average. Round intermediate calculations to four decimal places. - ○ 1.87% - ○ 2.20% - ○ 2.53% - ○ 2.75%
The real risk-free rate (\(r^*\)) is 2.8% and is expected to remain constant. Inflation is expected to be 8% per year for each of the next two years and 7% thereafter. The maturity risk premium (MRP) is determined from the formula: \(0.1(t - 1)%\), where \(t\) is the security’s maturity. The liquidity premium (LP) on all National Transmissions Corp.’s bonds is 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP): | Rating | Default Risk Premium | |---------------|----------------------| | U.S. Treasury | — | | AAA | 0.60% | | AA | 0.80% | | A | 1.05% | | BBB | 1.45% | National Transmissions Corp. issues 14-year, AA-rated bonds. What is the yield on one of these bonds? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average. Choices: - 5.45% - 12.04% - 11.29% - 12.59% Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true? - The yield on an AAA-rated bond will be higher than the yield on a BB-rated bond. - Higher inflation expectations increase the nominal interest rate demanded by investors.
Transcribed Image Text:The real risk-free rate (\(r^*\)) is 2.8% and is expected to remain constant. Inflation is expected to be 8% per year for each of the next two years and 7% thereafter. The maturity risk premium (MRP) is determined from the formula: \(0.1(t - 1)%\), where \(t\) is the security’s maturity. The liquidity premium (LP) on all National Transmissions Corp.’s bonds is 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP): | Rating | Default Risk Premium | |---------------|----------------------| | U.S. Treasury | — | | AAA | 0.60% | | AA | 0.80% | | A | 1.05% | | BBB | 1.45% | National Transmissions Corp. issues 14-year, AA-rated bonds. What is the yield on one of these bonds? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average. Choices: - 5.45% - 12.04% - 11.29% - 12.59% Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true? - The yield on an AAA-rated bond will be higher than the yield on a BB-rated bond. - Higher inflation expectations increase the nominal interest rate demanded by investors.
Expert Solution
Step 1: Define short and long term interest rate

"As per the policy, we can provide a solution to the first question only. Kindly raise the question for the solution to the other part."

A short term interest rates exists when the loan is taken for few years or months, quite similar to purchasing household appliances or electronic goods. However, a llong term interest rate is the loan taken for a many years or decades like purchasing a house or car. 



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