Assume that a series of inflation rates is 1 percent, 2 percent, and 4 percent,

Question

Assume that a series of inflation rates is 1 percent, 2 percent, and 4 percent, while nominal interest rates in the same three periods are 5 percent, 5 percent, and 6 percent, respectively.

a. What are the ex post real interest rates in the same three periods?
b. If the expected inflation rate in each period is the realized inflation rate in the previous period, what are the ex ante real interest rates in periods two and three?
c. If someone lends in period two, based on the ex ante inflation expectation in part b, will he or she be pleasantly or unpleasantly surprised in period 3 when the loan is repaid?

Explanation / Answer

b. If the expected inflation rate in each period is the realized inflation rate in the previous period, what are the ex ante real interest rates in periods two and three?

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