TUTE PROBLEMS WEEK 1 FINANCIAL SYSTEM & INTEREST RATES (Discuss Week 2)

1) Suppose you borrow $500 from your friend, agreeing to pay him back the $500 plus 7% nominal
interest in 12 months time. Assume inflation over the life of the contract is expected to be 4.25%.
a) What is the total dollar amount you will have to pay back?
b) Using the simplified Fisher Equation, what percentage of the interest payment is the result of the
real rate of interest?
c) If the nominal interest on the loan is fixed, what happens to the real rate of interest if the magnitude
of the expected annualised price-level change (rate of inflation) changes by 1 percentage point i.e
Pe = +/- 1%.
d) As a result (of 1) c) above), what do you observe regarding the effect of Pe on the real rate of
interest on your borrowings?
e) What is the implication of zero inflation for the real rate of interest?
2) Given the information in 1) above:
a) Recalculate 1(b) using the exact Fisher Equation to calculate the real rate of interest.
b) Increase/decrease the expected rate of inflation by 1 percentage point i.e Pe = +/- 1. Now
recalculate the real rate.
c) Compare the result with 1) above. (contemplate how significant the difference in the result will be
using the abbreviated Fisher Equation versus the exact Fisher Equation)
Other discussion points (for you to think about):
1. What sort of companies likely access Direct Finance?
2. Primary Market transactions are for the issue of new shares and bonds. Secondary markets are
for what?
A new share is sold in a primary market initial public offering. Who gets the proceeds?
An existing share is sold in a secondary market (eg ASX). Who gets the proceeds?
3. In some countries (e.g. Germany, Japan), long term government bonds provide negative yields
(negative nominal rates) at present. If expected inflation is low but positive, what does it mean for
the real rate? Why is it so?
[In Australia yields on Aussie Govt 10 yr bonds are at record lows1.88% at 8 July, 2016]
4. What factors influence shifts in the supply and demand for money (and the equilibrium interest
rate)?