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IAI Actuarial Core Principles · Business Economics · Role of money and interest rates in the economy

A bank offers a nominal interest rate of 9% a year. Expected inflation is 5% a year. Using the approximate Fisher relationship, what is the expected real interest rate, and what happens to the real rate if expected inflation rises to 7% while the nominal rate stays at 9%?

The real rate is about 4%, found as 9% nominal minus 5% expected inflation. If expected inflation rises to 7% with the nominal rate unchanged, the real rate falls to about 2%, so lenders are worse off in real terms.

  1. A4% falling to 2%Correct
  2. B14% falling to 16%
  3. C4% rising to 6%
  4. D2% falling to 4%
  5. 4% remaining 4%

Explanation

Real rate is approximately nominal minus expected inflation: 9% - 5% = 4%. When expected inflation rises to 7% with the nominal rate unchanged, the real rate becomes 9% - 7% = 2%. The rise option wrongly adds inflation or reverses the sign.

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