Question

1) Consider the following data fro the U.S economy.

Year	Interest Rates	Annual Inflation Rate
1981	14.03%	10.3%
1982	10.69%	6.2%
1983	8.63%	3.2%

a) Did borrowing costs rise or fall in the United States over the period? Explain your reasoning

b) Suppose in addition to the data given in question 1, you find a report from a bank dated 1981 that forecasts inflation increasing by 1% point in each of the following two years. What are the implied ex ante real interest rates?

Answer 1

(a) Since interest rates are stated nominally, given interest rates are assumed to be nominal interest rate.

Borrowing cost = Real interest rate = Nominal interest rate - Inflation rate

Borrowing cost, 1981 = 14.03% - 10.3% = 3.73%

Borrowing cost, 1982 = 10.69% - 6.2% = 4.49%

Borrowing cost, 1983 = 8.63% - 3.2% = 5.43%

Therefore, real cost of borrowing is increasing over the period, though nominal interest rate is decreasing.

(b) Ex-ante real interest rate = Nominal interest rate - Expected inflation rate

Ex-ante real interest rate, 1982 = 10.69% - (6.2 + 1)% = 10.69% - 7.2% = 3.49%

Ex-ante real interest rate, 1983 = 8.63% - (3.2 + 1)% = 8.63% - 4.2% = 4.43%