1. 8. (Appendix A2

) Suppose that the nominal prime interest rate for a one year loan is currently 6 percent.

a. If inflation is 1 percent per year, what is the current real interest rate?

b. Suppose that many people believe that the inflation rate is going to rise in the future—probably up to 2 percent to 3 percent or more within a few years. You want to borrow a sum of money for ten years and are faced with deciding between 1. A series of short-term, one-year loans. The interest rate on this year’s loan would be 6 percent, while future nominal interest rates are unknown.

2. A 10-year fixed-rate loan on which you would pay a constant 6.25 percent per year. If you agree with most people and expect inflation to rise, which borrowing strategy do you expect might give you the better deal?

Why? Explain your reasoning.