ECO 304L Chapter Notes - Chapter Unit 2: Ch 5-8,13: Walter Mondale, Nominal Interest Rate, Real Interest Rate

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greenwalrus59

7 Oct 2017

School

UT-Austin

Department

Economics

Course

ECO 304L

Professor

M O S T A S H A R I, S H A L A H

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Document Summary

Home mortgages in the 1970s: suppose you lend a friend ,000 for a year and you expect inflation to be 5 percent. If you charge your friend 5 percent interest, you will get back. This is more money than you lent, but it does not represent an increase in purchasing power. Since inflation was 5 percent, the extra 50 bucks you received was just enough to offset the effect of increased prices. The real value of your money has stayed the same: in this example the nominal interest rate was 5 percent. This is the interest rate actually quoted in financial contracts. Your purchasing power would have increased by approximately 4 percent. The real interest rate was 4 percent: conversely, if you had charged no interest at all the purchasing power of your money would have declined by about 5 percent when the loan was repaid.

Related Questions

During the last year you lent money at a nominal rate of 6 percent.Actual inflation was 1 percent, but people had been expecting 1.5percent . This difference between actual and expectedinflation

A. transferred wealth from the borrower to you and caused youractual real interest rate to be more than 0.5 percentage pointshigher than what you had expected.
B. transferred wealth from you to the borrower and caused youractual real interest rate to be more than 0.5 percentage pointslower than what you had expected.
C. transferred wealth from the borrower to you and caused youractual real interest rate to be 0.5 percentage points higher thanwhat you had expected.
D. transferred wealth from you to the borrower and caused youractual real interest rate to be 0.5 percentage points lower thanwhat you had expected.

Suppose I borrow $200,000 for one year at a fixed nominal interest rate of 7 percent.

(a) What is my nominal repayment next year?

(b) Suppose that at the time the loan was made, both the lender and I believed that the (ex-ante) rel interest rate on the loan would be two percent. Suppose the actual inflation rate over the life of the loan turns out to be 4 percent. What is the ex-post real interest rate? Does the inflation rate help me at the expense of the lender, or help the lender at my expense?

(d) Given that the lender and I agreed that the ex-ante real interest rate should be 2 percent, what nominal interest rate would I have been charged if the lender and I had expected inflation over the life of the loan to be 10 percent? 3 percent? 0 percent?

(e) Inflation increased enexpectedly during the 1970s. Explain why this helped someone who bought a house using a 30-year mortgage with fixed nominal interest rates in 1965, but not someone who bought a house using a 30-year mortgage with a fixed nominal interest rate in 1980.

yellowprairie-dog173

23.

Shoe-leather costs refer to the costs of:

	the raw material used in production.
	the increased number of transactions as inflation increases.
	living adjustments as inflation increases.
	the raw material used in production, the increased number of transactions as inflation increases, and living adjustments as inflation increases.

24.

Unit-of-account costs of inflation are the:

	costs associated with money being a less reliable unit of measurement.
	costs of transactions associated with avoiding the inflation tax.
	costs associated with businesses changing prices.
	transfers the government gets from printing money.

25.

Menu costs of inflation are the:

	costs associated with money being a less reliable unit of measurement.
	costs of transactions associated with avoiding the inflation tax.
	costs associated with businesses changing prices.
	revenue the government gets from printing money.

26.

Which statement is true?

	Unexpected inflation benefits lenders and hurts borrowers.
	Unexpected inflation benefits borrowers and hurts lenders.
	Unexpected inflation benefits borrowers but does not affect lenders.
	Unexpected deflation benefits lenders but does not affect borrowers.

27.

Suppose that the nominal rate of interest is 7 percent and the inflation rate is 3 percent. The real rate of interest is equal to:

	3 percent.
	4 percent.
	10 percent.
	7 percent.

28.

You have gone to the bank to borrow money for one year. The nominal annual interest rate is 7.5 percent. The real rate of interest is 4 percent. (Hint: what is the expected inflation rate?) Over the course of the year, overall prices increased by 3 percent. (Hint: What is the actual inflation rate?) This rate of inflation hurt the _____ because the actual rate of inflation was _____ than the anticipated rate of inflation.

	lender, higher
	lender, lower
	borrower, higher
	borrower, lower

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ECO 304L Chapter Notes - Chapter Unit 2: Ch 5-8,13: Walter Mondale, Nominal Interest Rate, Real Interest Rate

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