Frank is lending $1,000 to Sarah for two years. Frank and Sarah agree that Frank should earn a 2 percent real return per year. LO5

a. The CPI (times 100) is 100 at the time that Frank makes the loan. It is expected to be 110 in one year and 121 in two years. What nominal rate of interest should Frank charge Sarah?

b. Suppose Frank and Sarah are unsure about what the CPI will be in two years. Show how Frank and Sarah could index Sarah’s annual repayments to ensure that Frank gets an annual 2 percent real rate of return.