A lender expects to earn a real interest rate of 4.5% over the next 12 months. She charges a 9.25% (annual) nominal rate for a 12-month loan. What inflation rate is she expecting? If the lender is in a 30% marginal tax bracket, the borrower in a 25% marginal tax bracket, and they both have the same inflation expectations, what are the real after-tax rates each expects?
What will be an ideal response?
The first part she expected an inflation rate of 4.75%. We obtain this answer using the Fisher equation where i = r + ?e. For the second part we need to use a variation of the Fisher equation. The lender receives an after-tax nominal rate of 6.475% from which we subtract the inflation rate of 4.75% and the lender expects a real after-tax rate of 1.725%. The borrower expects to pay an after-tax real rate of 2.188%.
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What will be an ideal response?
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