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Chapter2_Real_and_Nominal_Interest_Rate_Discussio

# Chapter2_Real_and_Nominal_Interest_Rate_Discussio -...

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Expected Real Interest Rate o r i -  Π e o Π e - expected rate of inflation o r = real interest rate o i = nominal interest rate

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Real and Nominal Interest Rates and Inflation Example:
Real and Nominal Interest Rates and Inflation Example: o Suppose Diamond Jim wants to borrow \$1000 from  Scrooge and both agree that in the absence of inflation  a fair rate of interest is 4% o Diamond Jim pays back \$1040 at the end of the year

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o Now suppose inflation is 6% o Scrooge charges a 10% rate of interest o Scrooge will receive \$1100 which is \$1040 plus \$60 to  compensate for inflation o Loss in purchasing power due to inflation is 6% of \$1000  = \$60 Aside Notes: In class today I also said that if the real rate of interest if 4% and inflation is expected to be 6% then  Scrooge should charge a 10% nominal interest rate on the \$1000 loan.  However, if inflation is  expected to be 6% and turns out to be 7% then we say inflation is unanticipated and Scrooge will be

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