Suppose certain providers of finance are to be compensated for their rate of time preference by a discount rate of 3 per cent, at a time when inflation is anticipated to be 4 per cent. What overall return will they require on risk- free investments?
A) 1%
B) 1.1%
C) 12%
D) 7.1%

Question

Quizplus · Accepted Answer

The overall return required on risk-free investments can be calculated using the Fisher equation:

Nominal interest rate = Real interest rate + Inflation rate

In this case, we know the inflation rate (4%) and the discount rate (3%). To calculate the real interest rate, we subtract the inflation rate from the discount rate:

Real interest rate = Discount rate - Inflation rate 
Real interest rate = 3% - 4% 
Real interest rate = -1%

Since a negative real interest rate doesn't make sense, we can flip the sign and calculate the nominal interest rate:

Nominal interest rate = Real interest rate + Inflation rate 
Nominal interest rate = -(-1%) + 4% 
Nominal interest rate = 1% + 4% 
Nominal interest rate = 5%

Therefore, the providers of finance will require an overall return of 5%, which is closest to answer choice D (7.1% is too high and 1% and 1.1% are too low).

Suppose Certain Providers of Finance Are to Be Compensated for Their