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Nominal vs Real Interest Rates

# Nominal vs Real Interest Rates - Econ 12 Foster Spring 2010...

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Econ 12 – Foster Spring 2010 Nominal vs. Real Interest Rates An Example Tiny Tim wants to borrow \$1000 from Scrooge for one year. Scrooge is willing to lend him the money. Both agree that, in the absence of any inflation, a fair rate of interest would be 3%. Tiny Tim would pay back \$1030 to Scrooge at the end of one year for the privilege of having \$1000 now. Now let’s assume that, based on their experience, both men expect prices to rise by 6%. Scrooge knows that, given the expected inflation rate of 6%, if Tiny Tim only pays him \$1030 one year from today, that money will buy less than what \$1000 will buy today. So he decides to charge Tiny Tim 9% interest. If he charges Tiny Tim 9% interest, Tiny Tim would have to pay Scrooge \$1090 at the end of the year. This amount would cover expected rise in prices (inflation) of 6% as well as the loan fee (increased purchasing power) of 3% that Tiny Tim is willing to pay for the privilege of borrowing the money. This protects Scrooge from any losses in the transaction.

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Nominal vs Real Interest Rates - Econ 12 Foster Spring 2010...

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