Calculate the nominal interest rate and the Fisher equation.

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Chapter 8, Problem 9E

To determine

Calculate the nominal interest rate and the Fisher equation.

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Nelson, a management trainee at a large New York-based bank, is trying to estimate the real rate of return expected by investors. He notes that the 3-month T-bill currently yields 8 and has decided to use the consumer price index as a proxy for expected inflation, if the CPI is currently 2.5. What is the estimated real rate of interest?

Suppose I lend my friend Peter $100 for one year, and he agrees to repay me with interest. We each have an expectation that the inflation rate over the coming year will be 5 percent, and so we agree that he will pay me back at a nominal rate of 7 percent interest. a) What real rate of return do I expect to receive? b) What happens if inflation turns out to be 8 percent over the year? Who is made better off and who is made worse off? c) What happens if inflation turns out to be 3 percent over the year? Who is made better off and who is made worse off?

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