Inflation nominal interest rates and real rates The Republic

Inflation, nominal interest rates, and real rates.

The Republic of New South Brazillia, a small, developing island country in South Central America, is experiencing a very high inflation rate at this time. The annual inflation rate is 40%. If the real rate of interest is 2%, what nominal interest rates must the residents of New South Brazillia get to stay ahead of inflation and still have a reward for waiting? Use the approximate nominal interest rate equation and the true nominal interest rate equation to determine the rates.

Using the approximate nominal interest rate equation, what nominal interest rate must the residents of New South Brazillia get to stay ahead of inflation and still have a reward for waiting?

Using the true nominal interest rate equation, what nominal interest rate must the residents of New South Brazillia get to stay ahead of inflation and still have a reward for waiting?

All answers around up to 2 decimal places.

Solution

Real rate of interest that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower, and the real yield to the lender. The real interest rate of an investment is calculated as the amount by which the nominal interest rate is higher than the inflation rate.

The nominal interest rate is conceptually the simplest type of interest rate. It is quite simply the stated interest rate of a given bond or loan. This type of interest rate is referred to as the coupon rate for fixed income investments, as it is the interest rate guaranteed by the issuer that was traditionally stamped on the coupons that were redeemed by the bondholders.

Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling

Approximate nominal rate of interest equation is:

Nominal rate = real interest rate + inflation rate

= 2% + 40% = 42%

The residents of New South Brazillia should get interest on loan or bond more than 42% to stay ahead of inflation and to have a reward for waiting.

True nominal interest rate equation is:

(1 + nominal rate) = (1 + real interest rate) (1 + inflation rate)

(1 + nominal rate) = (1+2%)*(1+40%) = 142.80%

Nominal rate = 42.80%

The residents of New South Brazillia should get interest on loan or bond more than 42.8% to stay ahead of inflation and to have a reward for waiting.