Chapter 10, Problem 10P

To determine

Change in Interest Rate: Interest rate depends on several factors. One such factor is expected inflation rate. The relationship of interest rate and inflation rate is described by the Fisher effect.

Inflation: When the price of any good increases continuously for an interval of time it is called inflation. The formula to calculate inflation rate is:

$\text{Inflation}\text{Rate}=\text{Nominal}\text{Interest}\text{Rate}-\text{Real}\text{Interest}\text{Rate}$

Fisher Effect: According to this effect, when there is a rise in the expected inflation rate, then there is always a rise in the nominal interest rate provided loanable fund quantity and interest rate does not change.

Answer to Problem 10P

a. When Real inflation Rate is 4%

Given,

Nominal interest rate is 8%.

Real interest is3%.

Expected inflation is 5%.

The formula to calculate real interest rate is:

$\text{Real}\text{Interest}\text{Rate}=\text{Nominal}\text{Interest}\text{Rate}-\text{Inflation}\text{Rate}$

Substitute 8% for nominal interest rate and 4% for inflation rate as follows:

$\begin{array}{c}\text{Real}\text{Interest}\text{Rate}=8\%-4\%\\ =4\%\end{array}$

Explanation of Solution

• If the real inflation is 4%, then it means that the real interest paid by Mr. B is 4%. However, at the initial agreement (expected inflation 5%), he was paying only 3% as real interest.

• This shows that Mr. B is worse off and Mr. L is better off.

b. When Real inflation Rate is 7%

The formula to calculate real interest rate is:

$\text{Real}\text{Interest}\text{Rate}=\text{Nominal}\text{Interest}\text{Rate}-\text{Inflation}\text{Rate}$

Substitute 8% for nominal interest rate and 7% for inflation rate as follows:

$\begin{array}{c}\text{Real}\text{Interest}\text{Rate}=8\%-7\%\\ =1\%\end{array}$

• If the real inflation is 7%, then it means that real interest paid by Mr. B is 1%. However, at the initial agreement (at 5% expected inflation), he was paying 3% as real interest.

• This shows that Mr. B is better off and Mr. L is worseoff because now the real interest paid by Mr. B is less than earlier.