suppose that you want to take out a loan and that your local bank wants to charge you an annual real…

suppose that you want to take out a loan and that your local bank wants to charge you an annual real interest rate equal to 5%. assuming that the annualized expected rate of inflation over the life of the bond is 2%, determine the nominal interest rate that the bank will charge you. the bank will charge you a nominal interest rate of . what happens if, over the life of the loan, actual inflation is 1.5%? if actual inflation turns out to be 1.5% (lower than expected 2%), the real cost of borrowing will be . if the actual inflation turns out to be lower than the expected inflation, a. you will be better off than originally planned, since the real cost of borrowing turned out to be lower. b. you will be worse off than originally planned, since the real cost of borrowing turned out to be higher. c. you will be unaffected, since the actual inflation will have no impact on the nominal interest rate.

suppose that you want to take out a loan and that your local bank wants to charge you an annual real interest rate equal to 5%. assuming that the annualized expected rate of inflation over the life of the bond is 2%, determine the nominal interest rate that the bank will charge you. the bank will charge you a nominal interest rate of . what happens if, over the life of the loan, actual inflation is 1.5%? if actual inflation turns out to be 1.5% (lower than expected 2%), the real cost of borrowing will be . if the actual inflation turns out to be lower than the expected inflation, a. you will be better off than originally planned, since the real cost of borrowing turned out to be lower. b. you will be worse off than originally planned, since the real cost of borrowing turned out to be higher. c. you will be unaffected, since the actual inflation will have no impact on the nominal interest rate.

Answer

Explanation:

Step1: Recall the Fisher - equation

The Fisher - equation is $i = r+\pi^{e}$, where $i$ is the nominal interest rate, $r$ is the real interest rate, and $\pi^{e}$ is the expected inflation rate.

Step2: Calculate the nominal interest rate

We are given that $r = 5%$ and $\pi^{e}=2%$. Substitute these values into the Fisher - equation: $i=5% + 2%$.

Step3: Perform the addition

$i = 7%$.

Step4: Analyze the impact of lower - than - expected inflation

The real cost of borrowing is given by $r=i - \pi$. When actual inflation $\pi$ is lower than expected inflation $\pi^{e}$, the real cost of borrowing $r$ increases for a fixed nominal interest rate $i$. If actual inflation is lower than expected, borrowers are worse off because the real cost of borrowing is higher than they originally planned.

Answer:

The bank will charge you a nominal interest rate of 7%. If the actual inflation turns out to be lower than the expected inflation, you will be worse off than originally planned, since the real cost of borrowing turned out to be higher. So the answers are: 7%; B. you will be worse off than originally planned, since the real cost of borrowing turned out to be higher.