Real versus nominal interest rates A. Suppose the 30 year mortgage interest rate
ID: 2383626 • Letter: R
Question
Real versus nominal interest rates
A. Suppose the 30 year mortgage interest rate rises from 3 percent to 5 percent, and simultaneously the expected rate of inflationrises from 1 percent to 4 percent. What is the approximate change in the real interest rate? Will the demand for mortgages rise or fall as a result of thesechanges? Please explain.
B. In the year 2007, the Zimbabwe economy was estimated to have an inflation rate of 66,000 percent (i.e., =660). (That is, prices were 660 times higher by the end of the year!) What nominal annual interest rate would a Zimbabwe lender making a loan and expecting repayment in Zimbabwe dollars at the end of the year need to charge in order to get a real interest rate of 5 percent? Use the exact formula for the real interestrate. If instead the lender used the approximation formula, what nominal interest rate would have been charged?
Explanation / Answer
(1+NR)= (1+RR)(1+IR)
(1+.03)= (1+RR)(1+.01)
1+RR = 1.03/1.01
RR = 1.98
(1+.05) = (1+RR)(1+.04)
RR = 1.05/1.04-1
RR = .96
Change in Real rate will be. It will decrease from 1.98% to .96%
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