Question

Inflation, nominal interest rates, and real rates. The minister of finance for the State of Tranquility has just estimated the expected inflation rate for the coming year at 6.59%. If the real rate for the coming year is 4.32%, what should the nominal interest rates at the central bank of the State of Tranquility be for the coming year? 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 should be the nominal interest rate at the central bank of the State of Tranquility for the coming year? 10.91 % (Round to two decimal places.) Using the true nominal interest rate equation, what should be the nominal interest rate at the central bank of the State of Tranquility for the coming year? % (Round to two decimal places.)

Answer 1

a) Approximate Formula:

Nominal Rate of Return = Real Rate + Inflation

Nominal Rate of Return = 4.32% + 6.59% = 10.91%

b) Exact Formula

(1 + Nominal rate) = (1 + Real rate) * (1 + Inflation)

(1 + Nominal rate) = (1 + 4.32%) * (1 + 6.59%)

(1 + Nominal rate) = 1.0432 * 1.0659

1 + Nominal Rate = 1.1119

Nominal rate = 0.1119 = 11.19%