Question 1

Darius lent Alejandro $1,000 for one year with the understanding that Alejandro would repay $1,070. If the actual inflation rate was 7 percent, what was the real rate of interest Darius received?

Accepted Answer

The nominal interest rate was 7 percent (since $1,070 is $1,000 plus 7 percent interest). With an inflation rate of 7 percent, the real rate of interest is 0 percent because the nominal rate minus the inflation rate equals the real rate (7% - 7% = 0%).

Question 2

Suppose that you purchase a $5,000 bond that pays 7 percent interest annually and matures in five years. If you expect that the inflation rate during the next five years will be 2 percent annually, what real rate of return do you expect to earn?

Accepted Answer

To find the real rate of return, we need to adjust the nominal rate of return (7%) for inflation (2%). The formula for real rate of return is (1 + nominal rate)/(1 + inflation rate) -1. Plugging in the numbers, we get (1.07)/(1.02) -1 = 0.049 or 4.9%. Therefore, the real rate of return is 4.9%, which is closest to option B) 5%.

Question 3

You just bought a $1,000 bond that is scheduled to mature in ten years. If interest rates rise during the next six months, the market value (or price) of your bond will

Accepted Answer

When interest rates rise, the market value of existing bonds decreases. This is because the bond with the lower interest rate is less valuable than a newly issued bond with a higher interest rate. Therefore, the price of the $1,000 bond is likely to decrease if interest rates rise during the next six months.

Question 4

When persistent inflation is present, we would expect

Accepted Answer

Nominal interest rates are typically higher than real interest rates when persistent inflation is present because lenders demand a premium to compensate for the expected loss of purchasing power due to inflation.

Question 5

The inflationary premium is that portion of the interest rate that reflects

Accepted Answer

The inflationary premium is the portion of the interest rate that reflects the expected annual rate of decline in the purchasing power of money while a loan is outstanding. This is because lenders want to be compensated for the loss in value of their money due to inflation over the course of the loan.

Question 6

As the real interest rate in the domestic loanable funds market increases,

Accepted Answer

As the real interest rate increases, it becomes more attractive for foreign investors to invest in the domestic market, leading to a net inflow of capital from abroad.

Question 7

Of the following, who would most likely be hurt by an unanticipated increase in the rate of inflation?

Accepted Answer

Lenders who have made long-term loans at fixed interest rates would be hurt by an unanticipated increase in the rate of inflation because the money they receive back will be worth less than the amount they originally loaned out. This means that the real value of their earnings would have decreased. Individuals with fixed-rate home loans and Social Security recipients would be protected from inflation to some extent because their payments are adjusted for inflation. The U.S. federal government's debt load is not affected by inflation.

Question 8

Marquis borrowed $1,000 from Ayana for a year and agreed to repay her $1,050 at the end of the year. If the inflation rate was 3 percent, what is the real rate of interest Ayana received?

Accepted Answer

The nominal rate of interest that Ayana charged Marquis is 5 percent ($1,050 - $1,000 = $50, and $50/$1,000 = 0.05, or 5 percent). To find the real rate of interest, we need to adjust for inflation. If inflation was 3 percent, then the $1,050 that Ayana received at the end of the year would only be worth $1,019.42 in today's dollars ($1,050 / 1.03 = $1,019.42). Therefore, the real rate of interest that Ayana received is $19.42/$1,000 = 0.01942, or 1.942 percent. This is approximately 2 percent, so the answer is D.

Question 9

If a lender expects inflation to be 5 percent, and after a loan is made, actual inflation is 10 percent, which of the following will be true?

Accepted Answer

If actual inflation is higher than expected, the lender will receive a lower real interest rate than he expected because the nominal rate does not adjust for inflation. In other words, the lender will receive back dollars that are worth less than what he lent out.

Question 10

During a period of persistent inflation,

Accepted Answer

Nominal interest rates will eventually rise to reflect the expected rate of inflation, which means that lenders will receive compensation for the expected loss in purchasing power caused by inflation. Once borrowers and lenders fully anticipate the inflation rate, there is no reason for either party to systematically gain relative to the other. Therefore, both options B and C are correct. However, in the short run, borrowers may gain at the expense of lenders as nominal interest rates may not immediately adjust to reflect the increase in inflation.

Question 11

Suppose people expect inflation to be 3 percent during the next several years. When the real interest rate is 5 percent, the money, or nominal interest rate, will be

Accepted Answer

The answer of Suppose people expect inflation to be 3...

Question 12

If people suddenly anticipate that inflation will rise during the next year, which of the following is most likely?

Accepted Answer

When people anticipate that inflation will rise, they will demand higher nominal interest rates as compensation for the expected loss of purchasing power of their money. Lenders will have to raise nominal interest rates to protect their returns from being eroded by inflation.

Question 13

If the money interest rate is 7 percent and the inflationary premium 4 percent, the real interest rate is

Accepted Answer

Real interest rate = Money interest rate - Inflationary premium = 7% - 4% = 3%

Question 14

A firm's level of investment is tied to the interest rate

Accepted Answer

The interest rate represents the opportunity cost of investing in capital, meaning that when the interest rate is high, the opportunity cost of investing in capital increases, so the firm may choose to invest less. This relationship holds true regardless of whether the firm has to borrow or has already saved the funds to invest. B, C, and E are incorrect because they are either irrelevant (B and E) or assume that the firm must borrow in order to invest (C). A is incorrect because the relationship between investment and interest rate is not limited to cases where the firm has to borrow in order to invest, although it is certainly relevant in those cases.

Question 15

Suppose the annual rate of inflation has been 3 percent during each of the last three years and that borrowers and lenders have come to expect this rate of inflation. If the inflation rate unexpectedly rises,

Accepted Answer

When inflation unexpectedly rises, the real value of money repaid by borrowers is less than anticipated, benefiting borrowers at the expense of lenders.

Question 16

Initially, the nominal rate of interest is 8 percent and inflation is 4 percent. The nominal interest rate then rises to 12 percent and the inflation rate to 8 percent. It follows that the real rate of interest has

Accepted Answer

The real rate of interest is calculated by subtracting the inflation rate from the nominal interest rate. Initially, it is 8% - 4% = 4%. After the change, it is 12% - 8% = 4%. Therefore, the real rate of interest has remained the same.

Question 17

If the expected inflation rate is 3 percent and banks charge a 10 percent money rate of interest, the real rate of interest is

Accepted Answer

The real rate of interest is calculated as the nominal rate of interest minus the expected inflation rate. Therefore, the real rate of interest in this scenario is 10 percent - 3 percent = 7 percent.

Question 18

If a person earns an 8 percent nominal rate of interest on his savings account in a year when inflation is 9 percent, the person's real rate of interest is

Accepted Answer

The real rate of interest is calculated as nominal rate of interest - inflation rate. Therefore, the real rate of interest in this case is 8% - 9% = -1%, indicating a decrease in the purchasing power of the savings despite earning interest.

Question 19

People anticipate inflation will be 3 percent during the next several years. If this is true, when the real interest rate is 4 percent, the money interest rate will be

Accepted Answer

The money interest rate is equal to the real interest rate plus the anticipated inflation rate. Therefore, the money interest rate would be 7 percent (4 percent real interest rate + 3 percent anticipated inflation rate).

Question 20

Falling interest rates cause the market value of previously issued bonds to

Accepted Answer

When interest rates fall, the market value of existing bonds rises because their fixed interest payments become more attractive compared to new bonds issued at the lower current rates.

Quiz 9: An Introduction to Basic Macroeconomic Markets