Question

Kaitlin has $10,000 of savings that she may deposit with her local bank. Kaitlin wants to earn a real rate of return of at least 4 percent, and she is expecting inflation to be exactly 3 percent. What is the lowest nominal interest rate that Kaitlin would be willing to accept from her local bank?

1. 4 percent

2. 5 percent

3. 6 percent

4. 7 percent

Short answer

Option (d): 7 percent.

Step-by-step solution

Step 1:The relationship between nominal and real interest rate

The nominal interest is the amount of money the borrower has to pay to the lender for using the loan money. It is determined by using the current purchasing power of the currency (inclusion of inflation).

The following equation gives the relationship among real interest rate, inflation rate, and nominal interest rate:

Nominal Interest Rate = Real Interest Rate + Inflation Premium (Expected Rate of Inflation)

Calculating lowest nominal interest rate that would be accepted by Kaitlin

Given: The expected real interest rate is 4%, and inflation is 3%.

Nominal Interest Rate = 4% + 3%

Nominal Interest Rate = 7%

Therefore, Kaitlin needs at least a 7% nominal interest rate from the bank.