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Macroeconomic Canadian education

Chapter 4 Money and Inflation 65 The Real Cost of Borrowing and the Real Interest Rate In this exercise, we see why the real cost of borrowing is equal to the real interest rate. 5. Since a borrowers actual dollar payments are based on the nominal interest a. rate, it is sometimes difmicult to see why the real cost of borrowing is equal to the real interest rate. Consider a family that buys a new house for $300,000 and takes a mortgage loan equal to the full amount at 7 percent annual interest. The annu- al interest cost of the mortgage will equal $ 2/000 home is a real commodity, its nominal value will increase at the rate of inflation. If the expected rate of inflation is 4 percent, the home is expected to increase in value by about$ 2000 Consequently, the expected real cost of the mortgage is equal to the difference between the annual mortgage payments and the expected appreciation of the home. This amount equals $ a percentage of the initial loan, this amount equals percent. Thus, the expected real cost of the loan is equal to the ex ante real interest rate i E Since the each year each year. Expressed as percent. b. Suppose that there is unexpected inflation and the actual rate of inflation during the year is 6 percent. Since the mortgage loan was written in terms of the nomi- nal interest rate prevailing at the time that the loan was made, the annual mort- gage interest payment remains equal to $ . The nominal value of the home, however, now increases by the actual rate of inflation, that is, by percent, or by about $Consequently, the real cost of the mortgage is equal to $ actual real cost of the loan is equal to the ex post real interest rate, i -r, which each year, or percent of the initial loan. Thus, the equalspercent. 6. The Money Demand Function In this exercise, we use the money demand function
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