Question

The annual inflation rate is expected to be 5 percent over the next 3 years. Juan plans to take out a 3-year loan to purchase a car. If Juan decides not to take out a loan if the real interest rate exceeds 3 percent, the highest nominal interest rate he is willing to pay is:

Answer 1

The highest nominal interest rate he is willing to pay is 8.15%.

The highest nominal interest rate that Juan is willing to pay can be determined using the Fisher equation. The Fisher equation postulates that the nominal interest rate is a function of the real interest rate and the inflation rate.

Fisher effect equation : ( 1 + nominal interest rate) = (1 + real interest rate) x (1 + inflation rate)

(1.03) x (1.05) = ( 1 + nominal interest rate)

( 1 + nominal interest rate) = 1.0815

Nominal interest rate = 1.0815 - 1

Nominal interest rate = 8.15%

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