An investment offers a total return of 13 percent over the c

An investment offers a total return of 13 percent over the coming year. Bill Bernanke thinks the total real return on this investment will be only 8.0 percent.

What does Bill believe the inflation rate will be over the next year? (Do not round intermediate calculations. Round your answer to 2 decimal places (e.g., 32.16).)

Solution

Crude measure: The inflation rate is the difference between the nominal and the real return, or (13-8) = 5% in your example.

The Fisher equation, which shows the exact relationship between norminal interest rates, real interest rates, and inflation is :

       (1 + R) = (1 + r)(1 + h)           where R = total/nominal return rate, r = real return rate, h = inflation rate

        h = [(1 + .13) / (1 + .08)] – 1

           h = .04629 or 4.63%