Assume that the term structure effect and the default-risk premium remain unchanged and that households and firms have adaptive expectations.At the beginning of 2013,a bank is offering car loans at a nominal interest rate of 7% and the expected rate of inflation is 2 %,and at the beginning of 2014,the bank decreases the nominal interest rate to 5%.The real interest rate at the beginning of 2014 is
A) 2%.
B) 3%.
C) 5%.
D) This cannot be determined without being given the expected inflation rate for 2014.

Question

Quizplus · Accepted Answer

The real interest rate can be calculated using the formula:
Real Interest Rate = Nominal Interest Rate - Inflation Rate
At the beginning of 2013, the real interest rate was:
Real Interest Rate = 7% - 2% = 5%
Assuming the expected inflation rate for 2014 remains the same as 2%, the real interest rate at the beginning of 2014 would be:
Real Interest Rate = 5% - 2% = 3%
Therefore, the answer is B) 3%.

Assume That the Term Structure Effect and the Default-Risk Premium