A municipality issued bonds to finance its infrastructure projects. The bonds are supposed to pay 6.5% per year. A city engineer calculated the real rate of interest to be 3.5% next year. What inflation rate did the engineer assume?
A)2.7%
B)2.9%
C)4.8%
D)9.2%
E)22.2%

Question

Quizplus · Accepted Answer

The engineer assumed an inflation rate of 2.9%. This is because the real interest rate can be approximated by subtracting the inflation rate from the nominal interest rate (6.5% - 3.5% = 3.0%). However, the exact calculation involves the Fisher equation, which is (1 + nominal rate) = (1 + real rate) * (1 + inflation rate). Solving for the inflation rate gives a value close to 2.9%.

A Municipality Issued Bonds to Finance Its Infrastructure Projects