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The CPI (times 100) is 100 at the time that Frank makes the loan. It is expected to be 110 in one year and 121 in two years. What nominal rate of interest should Frank charge Sarah?

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jepessoa

Answer:

12% per year

Explanation:

first we must determine the inflation rate:

  • inflation rate year 1 = (110 - 100) / 100 = 10 / 100 = 0.1 or 10%
  • inflation rate year 2 = (121 - 110) / 110 = 11 / 110 = 0.1 or 10%

nominal interest rate = real interest rate + inflation rate = 2% + 10% = 12%

That way, Frank should collect = $1,000 x 1.12² = $1,254.40 in two years if he charges compound interest.

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