Question

Suppose you put $100 in the bank on January 1, 2017. If the annual nominal interest rate is 5 percent and the inflation rate is 5 percent, you will be able to buy ________ worth of inflation-adjusted goods on January 1, 2018.

	a.	$110
	b.	$95
	c.	$100
	d.	$105
	e.	$90

Practically, in the long run the real interest rate is equal to:

	a.	a savings account.
	b.	the marginal product of capital.
	c.	the rate of return to long-term bonds.
	d.	the return to housing.
	e.	the return to stock markets.

A risk a bank takes on by offering long-term fixed interest rate loans is the:

	a.	gain that could be made from offering short-term loans.
	b.	gains that could have been made if the money were invested in an alternative asset.
	c.	loss of real returns due to an unexpected inflation surprise.
	d.	loss of real returns due to anticipated inflation.
	e.	loss of customers wanting flexible interest loans.

If you decide to buy a house with an adjustable-rate mortgage (ARM), you are:

	a.	reducing your inflation risk.
	b.	taking on some of the lender’s inflation risk.
	c.	passing inflation risk to the lender.
	d.	exposing yourself to inflation risk.
	e.	increasing your mortgage payment.

Answer 1

2017

Amount= $100

Nominal Interest rate=5%

Inflation=5%

In 2018 inflation adjusted goods worth will be= Real interest Rate ( As it measures the purchasing power of an individual)

= Nominal- Inflation= 5%-5%=0 ( Due to nominal interest rate his amount increased but due to inflation the overall prices of goods also increased by the same amount, leaving no change in purchasing power.)

So even in 2018, the amount in his bank account will be $100 only as nominal interest rate equals inflation. Implying there is no change in his purchasing power.

As the nominal interest rate was 5% his purchasing power increased to $105 ; (100+100*5/100) but with increase in inflation as well of 5% his purchasing power reduced to its original value.

c) $100

A risk a bank takes on by offering long-term fixed interest rate loans is the:

c) loss of real returns due to an unexpected inflation surprise.

Since when the fixed interest rate loans are given there is a possibility of loss of real returns from inflation which were not taken account. As the price level in the economy keeps fluctuating which can make the deal unprofitable for the bank.If the inflation was anticipated it could have been taken into account while calculating the interest rate.

If you decide to buy a house with an adjustable-rate mortgage (ARM), you are:

ARM is a home loan where the interest rate changes periodically with time. Initially the interest rate is generally kept low.

b) taking on some of the lender’s inflation risk

The interest rate varies with the index of inflation and distributes the risk of inflation between the buyer and lender, as its not fixed interest rate on mortgage where only bears bears the cost of risk, here both shares the risk.