Suppose that on January 1, 2019 a bank lends $20,000 to a person. The bank and the individual both agree that the real interest rate charged on the loan should be 10% and the loan is going to be totally paid ($20,000 plus interest), in a one-time payment, on December 31, 2020. Suppose the two parties to this transaction can perfectly foresee what the inflation rate for this period is going to be. Given this information, what is the nominal rate the Bank has to charge on this loan? Assume that the CPI is computed at the beginning of each year.
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3) Suppose that on January 1, 2019 a bank lends $20,000 to a person. The bank and the individual both agree that the real interest rate charged on the loan should be 10% and the loan is going to be totally paid ($20,000 plus interest), in a one-time payment, on December 31, 2020. Suppose the two parties to this transaction can perfectly foresee what the inflation rate for this period is going to be. Given this information, what is the nominal rate the Bank has to charge on this loan? Assume that the CPI is computed at the beginning of each year.
Nominal interest rate refers to the interest rate before taking inflation into account. Nominal can also refer to the advertised or stated interest rate on a loan, without taking into account any fees or compounding of interest.
Therefore the interest charged by the bank is 10% only with no adjustments of inflation rate over the year.
The amount of money charged by the bank as interest in one year equals to ;
20000$× 10/100= 2000$.
The interest charged on next year = 22000$×10/100 = 2200$
So total interest paid at the end of loan = 2000+2200$ = 4200$.
Total amount paid at the end of period (one-time payment)= 20000+4200= 24200$
4) Assume the same conditions exist as in question 3 but now the bank and the borrower cannot predict the inflation rate perfectly. Assume that both the bank and the borrower expect an inflation rate of 8% over this period of time. Given this information, what is the nominal rate charged on the loan now? Given the actual inflation rate (from your calculations and the provided data), who wins from this loan contract and who loses from this loan contract? Explain your answer fully. What if the expected inflation rate is 4% during this period? Does your answer change as to who wins and who loses? And, if so, why did your answer change?
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