Question 1

If the annual real interest rate on a 10-year inflation-protected bond equals 1.5 percent and the annual nominal rate of return on a 10-year bond without inflation protection is 4.2 percent, what average rate of inflation over the ten years would make holders of inflation-protected bonds and holders of bonds without inflation protection equally well off?

Accepted Answer

To be as well off without inflation protection, one would need a real rate of return of 1.5 percent. This return is achieved when the nominal rate is 4.2 percent and the annual inflation rate is 2.7 percent,: i.e., 4.2 percent - 2.7 percent = 1.5 percent.

Question 2

If both the lender and borrower agree on an 8 percent interest rate, both expect a 4 percent inflation rate, and inflation turns out to be 4 percent, then ________ by the inflation.

Accepted Answer

When inflationary expectations are fulfilled, neither the lender nor the borrower is hurt by inflation.

Question 3

An investor purchasing an inflation-protected bond with a fixed annual real return of 1.75 percent will earn a nominal annual return of ________ percent if the actual inflation rate turns out to be 3.25 percent.

Accepted Answer

The inflation-protected investor earned a real return of 1.75 percent. If the actual inflation rate was 3.25 percent then the nominal interest rate was 5 percent: 1.75 percent + 3.25 percent = 5 percent.

Question 4

For a given nominal interest rate, an unexpectedly low inflation rate ________ the real interest rate.

Accepted Answer

Because the real interest rate equals the nominal interest rate minus the inflation rate, a lower than expected inflation rate increases the real interest rate. So the lender gets an unexpected bonus.

Question 5

If the bank agrees to make a loan at a 7 percent interest rate and the inflation rate is 3 percent, then 4 percent is the ________ rate.

Accepted Answer

The nominal rate is 7 percent and the inflation rate is 3 percent. The difference between these is the real interest rate of 4 percent.

Question 6

To obtain a given real rate of return, lenders must charge a ________ nominal interest rate in the face of increasing inflation.

Accepted Answer

This is the result of the "Fisher effect" which says that nominal interest rates in inflation rates move together.

Question 7

The Fisher effect is the tendency for ________ interest rates to be ________ when inflation is high.

Accepted Answer

The Fisher effect is the tendency for nominal interest rate to be high when inflation is high and low when inflation is low.

Question 8

The real cost of borrowing is unchanged when the ________ interest rate and the ________ rate increase by the same amount.

Accepted Answer

The real cost of borrowing is unchanged when the nominal interest rate and the inflation rate increase by the same amount.

Question 9

Assume one investor bought a 10-year inflation-protected bond with a fixed annual real rate of 1.5 percent and another investor bought a 10-year bond without inflation protection with a nominal annual return of 4.2 percent. If inflation over the 10-year period averaged 3 percent, which investor earned a higher real return?

Accepted Answer

The inflation-protected investor earned a real return of 1.5 percent while the other investor earned a real return of 1.2 percent because the nominal return of 4.2 percent was reduced by the annual inflation rate of 3 percent: $4.2 percent - 3 percent = 1.2 percent.

Question 10

The tendency for nominal interest rates to be high when inflation is high and low when inflation is low is known as:

Accepted Answer

The Fisher effect is the tendency for nominal interest rate to be high when inflation is high and low when inflation is low.

Question 11

Assume one investor bought a 10-year inflation-protected bond with a fixed annual real rate of 1.5 percent and another investor bought a 10-year bond without inflation protection with a nominal annual return of 4.2 percent. If inflation over the 10-year period averaged 2 percent, which investor earned a higher real return?

Accepted Answer

The inflation-protected investor earned a real return of 1.5 percent while the other investor earned a real return of 2.2 percent because the nominal return of 4.2 percent was reduced by the annual inflation rate of 2 percent: $4.2 percent - 2 percent = 2.2 percent.

Question 12

The real rate of return on holding cash ________ inflation is correctly anticipated.

Accepted Answer

Because the nominal rate of return on holding cash is always zero regardless of the rate of inflation, the real rate of return does not depend on whether or not inflation is correctly anticipated. Only the actual inflation rate will impact the real rate of return on holding cash.

Question 13

The nominal return on an inflation-protected bond equals a fixed real return:

Accepted Answer

The attractive feature of inflation-protected bonds is they add an inflation premium to a known real return.

Question 14

Inflation-protected bonds guarantee investors:

Accepted Answer

The attractive feature of inflation-protected bonds is they add an inflation premium to a known real return.

Question 15

To obtain a given real rate of return, lenders must charge a ________ nominal interest rate in the face of decreasing inflation.

Accepted Answer

This is the result of the "Fisher effect" which says that nominal interest rates in inflation rates move together.

Question 16

The real rate of return on holding cash is equal to:

Accepted Answer

Cash has a nominal return of 0 percent. Thus, the real return to holding cash is zero minus the inflation rate.

Question 17

If the annual real rate on a 10-year inflation-protected bond equals 1.9 percent and the annual nominal rate of return on a 10-year bond without inflation protection is 4.4 percent, what average rate of inflation over the ten years would make holders of inflation-protected bonds and holders of bonds without inflation protection equally well off?

Accepted Answer

To be as well off without inflation protection, one would need a real rate of return of 1.9 percent. This return is achieved when the nominal rate is 4.4 percent and the annual inflation rate is 2.5 percent, i.e., 4.4 percent - 2.5 percent = 1.9 percent.

Question 18

If the borrower and lender agree to a loan at 8 percent when the inflation rate is 3 percent, then 8 percent is the ________ interest rate and 5 percent is the ________ interest rate.

Accepted Answer

The nominal rate is 8 percent and the inflation rate is 3 percent, so the real interest rate is 5 percent.

Question 19

For a given nominal interest rate, an unexpectedly high inflation rate ________ the real interest rate.

Accepted Answer

If inflation is higher than expected the real rate of interest decreases, because the real interest rate equals the nominal interest rate minus the inflation rate.

Question 20

Unexpectedly high inflation ________ borrowers and ________ lenders.

Accepted Answer

This is one of the biggest costs of inflation: the transfer of wealth from lenders to borrowers in periods of unexpectedly high inflation.

Quiz 18: Measuring the Price Level and Inflation