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An increase in the rate of inflation will:(multiple choice) increase both the real and the nominal...

An increase in the rate of inflation will:(multiple choice)

  • increase both the real and the nominal rate of interest.

  • increase the nominal interest rate but will not affect the real interest rate.

  • increase the nominal interest rate while lowering the real interest rate.

  • decrease both the real and the nominal rate of interest.

  • increase the real interest rate but not affect the nominal interest rate.

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Answer #1

Real interest rate is calculated by adjusting the nominal interest rate for impact of inflation. Real interest rate is the rate that changes with the market due to the inflation rate. There is inverse relation between nominal interest rate and inflation rate that is with increase inflation the nominal rate decreases. An approximate real interest rate is calculated by deducting inflation rate from nominal interest rate. Say if nominal interest rate is 8% and inflation rate is 4%, real interest rate is 4% and now if inflation rate increases to 5% then real interest rate would be 3%. Therefore with increase in inflation rate the real rate of interest decreases.

Thus increase in inflation rate cause decrease in both the real and nominal rate of interest.

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