Drew wants to borrow $500 from Bob. Bob wants to make 4% real return on his money, so they both agree on an 4% interest rate paid next year. Both don't anticipate the -5% inflation next year. In this case
A) Drew will pay an 4% real interest rate.
B) Bob is better off.
C) Drew will pay an 13% nominal interest rate.
D) all of the above

Question

Quizplus · Accepted Answer

Given the -5% inflation, the real interest rate Bob earns is actually higher than the agreed 4% nominal rate. The real interest rate can be approximated by the formula: real interest rate ≈ nominal interest rate - inflation rate. Therefore, Bob earns a real interest rate of approximately 4% - (-5%) = 9%, making him better off than anticipated. Choices A and C are incorrect because Drew will pay a 4% nominal interest rate, not 13%, and the real interest rate for Bob is not 4% but higher due to negative inflation.

Drew Wants to Borrow $500 from Bob