Question

Suppose that the nominal rate of interest is 5% and the current expected rate of inflation is 2%. If the expected rate of inflation were to increase by 5% (to a new level of 7%) the nominal rate would rise to _____ according to the fisher effect and ______ according to the Darby/Feldstein effect. (for the Darby)/Feldstein effect assume a marginal tax rate of 40%)

a) 6%; 8%

b) 10%;10%

c) 10%;13.33%

d)12%;15.33%

Answer 1

According to Fisher, the real rate is constant so the nominal will increase by the same amount at which inflation rate is increased i.e., 5%. So, the nominal would rise to (5+5)%= 10%

Accordind to Darby/Feldstein, the nominal rate will increase by an amount of = (1/1-tax rate) * increase in inflation rate

i.e, (1/1-0.4)*5%= 8.33%

So, nominal rate will be = 5%+8.33% = 13.33%

Answer is (c) 10%;13.33%

Fisher equation is given by:- i=r+p

And Darby/Feldstein equation is given by:- i= (1/1-t)*(r+p)