when inflation is unexpected, interest rates are not set high enough to compensate lenders for the falling value of money. how to interpret the above statementH

Wolwol, It’s perfectly clear for me. You know that every nominal interest rate includes inflation premium. So, if expected inflation rate is for example 3%, banks will include this as an inflation premium in their interest rates. Now, in situation where inflation rate is higher than anticipated (unexpected inflation rate), banks interest rates are not set high enough.

wolwol, when inflation is unexpected (“underestimated” would be a better description), interest rates will be not be sufficiently high to compensation lenders for the deterioration of their purchasing power. Your books should discuss “nominal” and “real” interest rates, cash flows, and returns. Nominal figures aren’t adjusted for inflation, whereas real figures do reflect the impact of inflation. The calculation of the nominal interest rate may help clarify this relation for you: 1 + r_nominal = (1 + r_real)*(1 + Inflation) A quick example: Assume I require a real return of 5% of the money I lend. I estimate the rate of inflation will be 2% over the period for which I will lend funds, so I charge a nominal interest rate of 7.1% (= 1.05*1.02 - 1). So say I’ve underestimated inflation, which turns out to be 3%. Now my real return is 3.981% (= 1.071/1.03 - 1), instead of the 5% I required. Otherwise, the statement you reprinted is accurate and mostly self-explanatory. If you can specify the source of your confusion, we can possibly clarify things further.

3x to both of you. I tried to figure it out with the supply and demand curve of capital market, to see how lender’s surplus is affected. if the real interest rate decreases, the supplier’s surplus will be reduced. then the question narrows down to how underestimated inflation affect real interest rate. but the formular is also very helpful. hiredgens, your formular is a little bit different from the cfa1 text, which is r_nominal=r_real+inflation hiredguns1 Wrote: ------------------------------------------------------- > wolwol, when inflation is unexpected > (“underestimated” would be a better description), > interest rates will be not be sufficiently high to > compensation lenders for the deterioration of > their purchasing power. Your books should discuss > “nominal” and “real” interest rates, cash flows, > and returns. Nominal figures aren’t adjusted for > inflation, whereas real figures do reflect the > impact of inflation. > > The calculation of the nominal interest rate may > help clarify this relation for you: > > 1 + r_nominal = (1 + r_real)*(1 + Inflation) > > A quick example: > > Assume I require a real return of 5% of the money > I lend. I estimate the rate of inflation will be > 2% over the period for which I will lend funds, so > I charge a nominal interest rate of 7.1% (= > 1.05*1.02 - 1). > > So say I’ve underestimated inflation, which turns > out to be 3%. Now my real return is 3.981% (= > 1.071/1.03 - 1), instead of the 5% I required. > > Otherwise, the statement you reprinted is accurate > and mostly self-explanatory. If you can specify > the source of your confusion, we can possibly > clarify things further.

Do yourself a favor and also think about how unanticipated interest affects the whole picture – wages for laborer versus employers, interest rates for borrowers versus lenders… good general concept to know.

wolwol Wrote: ------------------------------------------------------- > hiredgens, your formular is a little bit different > from the cfa1 text, which is > r_nominal=r_real+inflation wolwol, the formula to which you’re referring is a linear approximation for the equation I used. I don’t recall whether any LOS require you to know both, but they’re pretty similar and result in approximately equal values.

mcf underestimated inflation? if inflation is underestimated, wage is not high enough to compensate the labor, labor lose and employers gain; lenders lose and borrowers gain if inflation is overestimated, vice verse.

joredguns1 good to know