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CHAPTER 4 THE LEVEL OF INTEREST RATES 4. The one-year 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 one-year nominal rate of interest? Assuming the Fisher effect, the current 1-year 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 one-year and a five-year 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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