Suppose that the nominal rate of interest is 5 percent and the inflation premium is 1 percent.

What is the real interest rate? %

Alternatively, assume that the real interest rate is 4 percent and the nominal interest rate is 6 percent.

What is the inflation premium? %

1.     4%

2.    2%

Interest rates are rounded off to nearest whole number.

Explanation:

Fisher effect formula determines the relationship between the Nominal rate, Real rate and inflation rate.

Fisher effect formula is as follows

1 + nominal rate = ( 1 + real rate ) ( 1 + inflation rate )

1.

1 + 5% = ( 1 + real rate ) ( 1 + 1% )

1.05 =  ( 1 + real rate ) x 1.01

1 + real rate = 1.05 / 1.01

1 + real rate = 1.0396

real interest = 1.0396 - 1 = 0.0396 = 3.96% = 4%

2.

Inflation premium = [ ( 1+ nominal rate ) / ( 1+ real rate ) ] -1

Inflation premium = [ ( 1+ 6% ) / ( 1+ 4% ) ] -1

Inflation premium = [ ( 1.06 / 1.04 ] -1

Inflation premium = 1.0192 - 1

Inflation premium = 0.0192

Inflation premium = 1.92%

Inflation premium = 2%

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