4.2 nominal vs real interest rates

RIR is 3% RIR + 2% = 5%

banks charge 5% interest on all loans what is the real interest rate if the expected inflation is 2%?

lenders (banks) because inflation rate is lower than anticipated

banks make fixed rate loans to businesses at 9%, expecting inflation rate to be 4% if inflation ends up being 2%, are the lenders (banks) or borrowers better off?

11% 9 - 2 = 7 7 + 4 = 11

banks make loans with flexible interest rates to businesses at 9% expecting inflation rates to be 2% if inflation ends up being 4%, what is the new nominal interest rate?

no change because NIR was flexible

banks make loans with flexible interest rates to businesses at 9% expecting inflation rates to be 2% if inflation ends up being 4%, what is the new real interest rate?

NIR = 1% 3 + (-2) = 1

expected inflation rate is 3% banks are earning a real rate of return that is -2% what is the nominal interest rate banks are charging?

NIR = RIR + inflation (nominal interest rate = real interest rate + inflation)

fisher equation

1% RIR + 5 = 6

frank buys a bond with a 6% interest rate he is expecting the real rate of return of 3% inflation ended up being 5% how much is frank's real rate of return?

3% 3 + inflation = 6

frank buys a bond with a 6% interest rate he is expecting the real rate of return of 3% what is he expecting the inflation rate to be?

8% 6 + 2 = 8 (RIR + inflation = NIR)

if inflation is expected to be 2% and lenders want to earn a real interest rate of 6% what should they charge on loans?

anticipated inflation

increases in the price level that occur at the expected rate

11% 7 + 4 = 11

the expected inflation rate is 7% over the next two years you want to take out a 2-year loan, but you will not take out the loan if real interest rate exceeds 4% what is the highest interest rate you are willing to pay?

4% RIR + 3 = 7

Violet has a fixed interest savings deposit with nominal interest rate of 7% with no expected inflation if inflation rate is now expected to be 3% what is the new real interest rate?

7% (no change because NIR was fixed)

Violet has a fixed interest savings deposit with nominal interest rate of 7% with no expected inflation if inflation rate is now expected to be 3% what is the new nominal interest rate?

flexible interest rate

an interest rate that changes with inflation

fixed interest rate

an interest rate that does not change

to describe the impact of inflation on nominal and real interest rates

purpose of the fisher equation

nominal interest rate

rates paid for on a loan, and not adjusted for inflation

nominal interest rates

rates you see when doing business with a financial institution

real interest rates

real rate of return earned on financial assets or paid back loans, adjusted for inflation

real rate of return

the nominal rate of return minus the inflation rate

fisher effect

the relationship between nominal returns, real returns, and inflation

real rate of return falls

what happens to real rate of return on financial assets when there is unexpected inflation?

real value of financial assets fall

what happens to the value of a financial asset when real rate of return falls?

borrower

who is better off during higher unanticipated inflation, borrowers or lenders?

they are getting dollars that are less valuable

why are lenders worse off with higher unanticipated inflation?

they pay back loans with dollars of less value

why borrowers are better off with higher unanticipated inflation?