Question

Assume that during the past year the consumer price index increased by 1.5 percent and the securities listed below returned the following nominal rates of return.

U.S Government T-bills 5.50%
U.S Government Long-term bonds 6.25
A. What are the nominal rates of return for each of these securities?
B. If next year the nominal rates all rise by 10 percent (i.e. multiply by 1.1, do NOT add 0.10) while inflation climbs from 4 percent to 5 percent, what will be the real rate of return on each security?

Answer 1

A)

U.S Government T-bills 5.50%

U.S Government Long-term bonds 6.25%

B)

real rate of return = [(1 + nominal rate) / (1 + inflation rate)] - 1

U.S Government T-bills 5.50%

nominal rate = 5.5% x 1.1= 6.05%

inflation rate = 5%

real rate of return = [(1 + 6.05%) / (1 + 5%)] - 1 = 1%

U.S Government Long-term bonds 6.25

nominal rate = 6.25% x 1.1= 6.875%

inflation rate = 5%

real rate of return = [(1 + 6.875%) / (1 + 5%)] - 1 = 1.79%