Suppose you borrow $100 of principal that must be repaid at the end of two years, along with interest of 4 percent per year. If the annual inflation rate turns out to be 8 percent,


(a) What is the real rate of interest on the loan?

(b) What is the real value of the principal repayment?

To find the real rate of interest on the loan, we need to adjust the nominal interest rate by the inflation rate. Here's how you can calculate it:

(a) Real rate of interest on the loan:

Step 1: Calculate the nominal interest: $100 * 4% = $4.

Step 2: Calculate the inflation adjustment: $100 * 8% = $8.

Step 3: Subtract the inflation adjustment from the nominal interest rate: $4 - $8 = -$4.

Step 4: Divide the result by the original loan amount: -$4 / $100 = -0.04, or -4%.

Therefore, the real rate of interest on the loan is -4%.

(b) To calculate the real value of the principal repayment, we need to adjust it for inflation. Here's how you can do it:

Step 1: Calculate the inflation adjustment: $100 * 8% = $8.

Step 2: Subtract the inflation adjustment from the original loan amount: $100 - $8 = $92.

Therefore, the real value of the principal repayment would be $92.