Final answer:
The real interest rate is calculated by subtracting the expected inflation rate from the nominal interest rate, resulting in a 4% real interest rate when the nominal rate is 7% and inflation is 3%. Deflation can increase the real interest rate, leading to higher real costs for borrowers and potentially causing economic hardships. Taxes on interest income are based on nominal gains, not accounting for inflation, which can affect individuals financially.
Step-by-step explanation:
If the nominal interest rate is 7% and the expected inflation rate is 3%, then to calculate the real interest rate, we subtract the rate of inflation from the nominal interest rate. In this case, the real interest rate would be 4% (7% nominal rate - 3% inflation rate).
This real interest rate represents the actual increase in purchasing power that a lender would experience, and it's an important consideration for both lenders and borrowers.
For instance, if inflation is higher than expected, the lender could end up with a lower real interest rate than anticipated, whereas deflation can increase the real interest rate, potentially leading to difficulties for borrowers.
The impact of inflation and deflation on the real interest rate is critical because it affects the real cost of borrowing. For example, if there is deflation of 2%, the real interest rate would be 9% (7% nominal rate + 2% deflation), meaning the real cost of borrowing has increased for borrowers, as their debt would increase in value in real terms.
This can have significant economic implications, potentially leading to a decrease in aggregate demand and an increased risk of recession as banks suffer losses and become less willing to issue new loans.
It's also worth noting the interaction of taxes with nominal and real interest rates. Income tax is levied on the nominal interest income, without considering the effects of inflation. Thus, even in a scenario where the real interest rate is zero or negative due to high inflation, an individual would still owe taxes on the nominal gains, which can further affect their economic situation.