CHAPTER 4
THE LEVEL OF INTEREST RATES
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%.
5.
The following annual inflation rates have been forecast for the next 5 years:
Year 1
3%
Year 2
4%
Year 3
5%
Year 4
5%
Year 5
4%
Use the average annual inflation rate and a 3% real rate to calculate the appropriate contract rate for a
oneyear and a fiveyear loan.
How would your contract rates change if the year 1 inflation forecast
increases to 5%?
Discuss the difference in the impact on the contract rates from the change in
inflation.
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 Spring '11
 Burns
 Inflation, real rate

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