Monique lends Taylor $1,200 on March 15, 2009. Taylor is expected to return $1,260 on March 14, 2010. Monique expects inflation over the one-year period to be 2%. What is the real interest rate that Monique desires

Real rate of interest = 2.9%

Explanation:

The fishers' equation expresses the relationship between nominal interest rate, real interest rate and the inflation rate

The nominal rate of interest

= (1260/1200 - 1) * 100

= 5%

The fisher's equation is given as

(I+N) = (1+R) (1+F)

N - Nominal rate of interest

R - Real rate of interest

F - Inflation rate

Real rate of Interest

= (1+N) / (1+F) - 1

= 1.05 / (1.02) - 1

=2.9%

2.94%

Explanation:

Real Rate of Return is the actual rate of return that an investor gets from investment excluding any inflation effect.

Present Value = PV = $1,200

Future Value = FV = $1,260

Numbers of period = n = 1 year

Use Following Formula to calculate the nominal Interest rate

FV = PV x (1 + r) ^n

$1,260 = $1,200 x (1 + r)

$1,260 / $1,200 = 1+r

1.05 = 1 + r

r = 1.05 - 1 = 0.05 = 5%

As the 5% is the Nominal Interest rate

we Will Use the Fisher Effect formula to calculate the real Interest rate

1 + Nominal Interest Rate = (1 + Real Interest Rate) x (1 + Inflation Rate)

1 + 5% = (1 + Real Interest Rate) x (1 + 2%)

1 + 0.05 = (1 + Real Interest Rate) x (1 + 0.02)

1.05 = (1 + Real Interest Rate) x 1.02

1 + Real Interest Rate = 1.05 / 1.02

1 + Real Interest Rate = 1.0294

Real Interest Rate = 1.0294 - 1

Real Interest Rate = 0.0294 = 2.94%