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Chapter 4 Recommended EndofChapter Problems and Solutions
1.
What factors determine the real rate of interest?
The real rate of interest is determined by:
(a) individual time preference for consumption, and (b)
the return that firms expect to earn on their real capital investments.
In equilibrium, the real rate of
interest is determined when desired saving equals desired investment.
3.
What is the "Fisher effect"?
How does it affect the nominal rate of interest?
The Fisher effect is Irving Fisher’s hypothesis that expected inflation is embodied in current
nominal interest rates.
Assuming the ability to forecast expected inflation, nominal rates should vary
directly with expected inflation.
4.
The oneyear real rate of interest is currently estimated to be 4 percent.
The current
annual rate of inflation is 6 percent, and market forecasts expect the annual rate of inflation to be 8
percent.
What is the current oneyear nominal rate of interest?
Assuming the Fisher effect, the current 1year nominal rate should be 12 percent, the sum of the
real rate (4%) plus the expected inflation rate (8%), an approximate but illustrative way of estimating the
answer.
The correct way to deal with compounding rates is to multiply (1+.04)(1+.08)  1 = 12.32%.
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This note was uploaded on 06/06/2011 for the course FINA 4000 taught by Professor Staff during the Spring '08 term at University of Georgia Athens.
 Spring '08
 Staff
 Interest

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