Let the expected rate of inflation equal 10 percent and the corresponding nominal rate of interest be 15 percent. If the rate of depreciation were 10 percent and the price of a piece of capital $10,000, then an entrepreneur charging the appropriate rental price of capital
A) would earn an extra 2 percent in real return if actual inflation were 8 percent instead of 10%.
B) would earn the same 5 percent real return regardless of what actual inflation happened to be.
C) would earn 17 percent in real return if actual inflation were 8 percent instead of 10 percent.
D) would earn something less than 5 percent if actual inflation were 8 percent instead of the anticipated 10 percent.
E) none of the above.

Question

Quizplus · Accepted Answer

The real return is calculated by adjusting the nominal return for inflation. If the expected inflation is 10% and the nominal interest rate is 15%, the expected real return is 5% (using the approximation formula real rate ≈ nominal rate - inflation rate). If actual inflation is 8% instead of 10%, the real return increases because the nominal rate stays the same while the inflation adjustment is smaller. The real return would be approximately 7% (15% - 8%), which is 2% higher than the expected 5% real return.

Let the Expected Rate of Inflation Equal 10 Percent and the Corresponding