Class 12 "and 15" Completed

How many cookies can you buy with 110 k new cookie

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How many cookies can you buy with $110? K New cookie price is $1.05 K So with $110, you can buy $110/$1.05 = 104.76 cookies. – You are 4.76 cookies better off (=4.76%) compared to last year. – Your purchasing power went up by 4.76%. 5
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6 The Fisher Effect K Relationship between nominal interest rates, real interest rates, and the rate of inflation ( π ). K This can be re-written as: K Which can be approximated for low inflation rates as: 1 + r real = 1 + r nom 1 + ! = Growth in Money Growth in Prices r real = 1 + r nom 1 + ! ! 1 = 1 + r nom 1 + ! ! 1 + ! 1 + ! = 1 + r nom ! (1 + ! ) 1 + ! = r nom ! ! 1 + ! r real ! r nom " ! or r nom ! r real + !
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7 The Fisher Effect and Oatmeal Raisin Cookies K For our example above, this means: r nom = 10% π = 5% The approximation results in a real rate of 5% % 76 . 4 05 . 1 05 . 0 1 . 0 1 = = + = π π nom real r r
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8 iClicker Example: Real World Real Rates Example K In 2000, short-term Canadian bond rates were about 5.8% and the inflation rate was about 3%. K In 2003, interest rates were about 2.7% and the rate of inflation was 3.1%. K What were the real returns for 2000 and 2003, respectively? a) 2.8%; -0.4% b) 2.8%, 0.4% c) 2.7%, - 0.39% d) 2.7%, 0.39% e) None of the above.
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9 iClicker Example: Real World Real Rates Example K In 2000, short-term Canadian bond rates were about 5.8% and the inflation rate was about 3%. K In 2003, interest rates were about 2.7% and the rate of inflation was 3.1%. K What were the real returns for 2000 and 2003, respectively? Correct solution is c: K For 2000: K For 2003: % 7184 . 2 1 03 . 1 058 . 1 = = real r % 3880 . 0 1 031 . 1 027 . 1 = = real r
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10 Real and Nominal Interest Rates: Ex-Ante and Ex-Post K When a lending or borrowing decisions is made, the nominal interest rate is typically known. The rate of inflation over the investment horizon is unknown, and therefore the real rate of return is unknown as well. Therefore ex-ante, nominal interest rates are the sum of an expected real interest rate plus the expected rate of inflation. In any given year, the expected rate of inflation is unlikely to be equal to the actual (ex-post) rate of inflation. K So in any given year, the actual (ex-post) real rate of return will be different from the ex-ante expected real rate of return. Which is OK as long as on average, there is no bias towards either over- or underestimating inflation so that over longer time horizons, ex- ante and ex-post real returns are the same.
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Mommy, Mommy, Where Do Interest Rates Come From?
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