Question

At present, the nominal interest rate is 7 per cent, and the expected inflation rate is 5 per cent. The current year is the base year for the price index used to calculate inflation.

a. What is the real interest rate?

b. What is the anticipated value of the price index next year?

Short answer

a. The real interest rate is$2\%$

b. The anticipated value of the price index next year is$105$.

Step-by-step solution

part (a) introduction

Now, calculating the real interest rate,

Real interest rate = nominal interest rate - expected inflation

$\Rightarrow 7\%-5\%$

$=2\%$

The real interest rate is$2\%$.

part (b) explanation

Now, calculating the anticipated price index for the following year,

$\Rightarrow 100+5=105$

(The anticipated price index of the following year = price index of base year - expected inflation)

The anticipated price index for the following year is$105$.