Question

Boris Borrower and Lynn Lender agree that Lynn will lend Boris $10,000 and that Boris will repay the $10,000 with interest in one year. They agree to a nominal interest rate of 8%, reflecting a real interest rate of 3% on the loan and a commonly shared expected inflation rate of 5% over the next year.

Assume that there is a fall of 2 percentage points in the expected future inflation rate. How will the real interest rate be affected by this change?

		will rise from 3% to 5%
		will rise from 3% to 6%
		will fall from 3% to 1%
		There will be no change.

Answer 1

Option A ie real interest rate will rise from 3% to 5%

The Fisher Effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation

Initial Situation

Nominal Interest Rate = 8%

Expected Inflation Rate = 5%

Real Interest Rate = Nominal Interest Rate - Expected Inflation Rate

= 8% - 5% = 3%

Now the expected inflation rate will fall by 2%

So, the expected inflation rate will be = 5% - 2% = 3%

Real Interest Rate = 8% - 3% = 5%

This means that real interest will rise from 3% to 5%