What If Inflation Is Anticipated To Be 5 Percent During T

questionif Inflation Is Anticipated To Be 5 Percent During The Next

Identify the appropriate nominal interest rate for a risk-free one-year loan, given that anticipated inflation is 5 percent and the real rate of interest is 5 percent.

Question: If inflation is anticipated to be 5 percent during the next year, while the real rate of interest for a one-year loan is 5 percent, then what should the nominal rate of interest be for a risk-free one-year loan? A 5 percent B 10 percent C 25 percent D None of the above

Sample Paper For Above instruction

The relationship between nominal interest rates, real interest rates, and inflation is fundamental in understanding the cost of borrowing and the return on investments. According to the Fisher Equation, the nominal interest rate (i) can be approximated by the sum of the real interest rate (r) and expected inflation (π): i ≈ r + π. This relationship indicates that if investors expect inflation to be 5 percent and the real interest rate is 5 percent, then the nominal rate should reflect both components to maintain the purchasing power of money over time.

Applying the Fisher Equation, the nominal interest rate (i) would be:

i = r + π = 5% + 5% = 10%

Thus, the expected nominal rate on a risk-free one-year loan should be approximately 10 percent. This rate ensures the lender receives compensation for both the real return and the expected inflation. If the nominal interest rate were set lower than this, the lender would effectively be losing purchasing power due to inflation. Conversely, setting it higher would provide a cushion against unexpected inflation but might make borrowing more expensive than necessary.

Understanding this relationship is essential for investors and policymakers. It influences central bank decisions on interest rates, guides borrower expectations, and helps in assessing the real yield of investments. Accurate inflation expectations are vital; if actual inflation differs significantly from anticipated levels, the real returns and economic stability can be affected.

In conclusion, considering the provided data, the appropriate risk-free nominal interest rate for a one-year loan, given an expected inflation of 5 percent and a real interest rate of 5 percent, would be 10 percent as per the Fisher approximation formula.

References

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