**Understanding Nominal and Real Interest Rates**Suppose the inflation premium is 2 percent and the nominal interest rate is 1 percent.a. What is the real interest rate?b. What if the inflation premium is 3 percent while the nominal interest rate is 0.5 percent?**Explanation:**The real interest rate can be calculated by adjusting the nominal interest rate to remove the effects of inflation. The formula is:\[ \text{Real Interest Rate} = \text{Nominal Interest Rate} - \text{Inflation Premium} \]**Scenario 1:**- Inflation premium = 2%- Nominal interest rate = 1%Real interest rate = 1% - 2% = -1%**Scenario 2:**- Inflation premium = 3%- Nominal interest rate = 0.5%Real interest rate = 0.5% - 3% = -2.5%These calculations show the impact of inflation on the purchasing power of money over time, highlighting how inflation can erode real returns.

Given Inflation premium = 2 % Nominal interest rate= 1 % a. Real interest rate = Nominal interest rate – inflation premium = -1 % b. if inflation premium is 3 % and nominal rate is 0.5% then real rate = nominal – inflation = 0.5 – 3 % = - 2.5 %

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Suppose the inflation premium is 2 percent and the nominal interest rate is 1 percent. a. What is the real interest rate? b. What if the inflation premium is 3 percent while the nominal interest rate is 0.5 percent?

Suppose the inflation premium is 2 percent and the nominal interest rate is 1 percent. a. What is the real interest rate? b. What if the inflation premium is 3 percent while the nominal interest rate is 0.5 percent?

ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

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Question

**Understanding Nominal and Real Interest Rates**

Suppose the inflation premium is 2 percent and the nominal interest rate is 1 percent.

a. What is the real interest rate?

b. What if the inflation premium is 3 percent while the nominal interest rate is 0.5 percent?

**Explanation:**

The real interest rate can be calculated by adjusting the nominal interest rate to remove the effects of inflation. The formula is:

\[ \text{Real Interest Rate} = \text{Nominal Interest Rate} - \text{Inflation Premium} \]

**Scenario 1:**
- Inflation premium = 2%
- Nominal interest rate = 1%

Real interest rate = 1% - 2% = -1%

**Scenario 2:**
- Inflation premium = 3%
- Nominal interest rate = 0.5%

Real interest rate = 0.5% - 3% = -2.5%

These calculations show the impact of inflation on the purchasing power of money over time, highlighting how inflation can erode real returns.

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