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Suppose Sally borrows $1,000 from Harry for one year and agrees to pay a nominal interest rate of 10%. When she borrows the money, both she and Harry expect an inflation rate of 5%.
The expected real interest rate on the loan is _______ %.Suppose that when Sally pays back the loan after one year, the actual inflation rate turns out to be 2%. The actual real interest rate on the loan is ________ %.a. If the inflation rate turned out to be higher than expected, then:_________. b. But if inflation turned out to be lower than expected, then:________.

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Answer:

The expected real interest rate on the loan is 5%.Suppose that when Sally pays back the loan after one year, the actual inflation rate turns out to be 2%. The actual real interest rate on the loan is 8%.

a. If the inflation rate turned out to be higher than expected, then: the real interest rate would be lower than expected.

b. But if inflation turned out to be lower than expected, then: the real interest rate would be higher than expected.

Explanation:

Expected real interest rate = nominal interest rate - expected inflation = 10% - 5% = 5%

Actual interest rate = nominal interest rate - actual inflation rate = 10% - 2% = 8%

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