Final answer:
An expected inflation rate of 2% results in interest rates increasing to compensate for the loss of purchasing power. Financial markets and institutions adjust interest rates to stay ahead of inflation, ensuring that the real value of money is maintained over time. Optipn a) Increasing.
Step-by-step explanation:
An expected inflation rate of 2% generally results in interest rates increasing. This is because lenders will want to maintain their purchasing power in the face of rising prices due to inflation. Governments and financial institutions often index wages and interest rates to inflation to prevent the loss of real income and to ensure that the repayment of loans reflects the real value of money over time. Inflation impacts economies differently, with low inflation rates around 2% to 4% not being a sign of crisis, while higher rates of inflation, particularly hyperinflation, can be damaging.
When the government has borrowed money at a fixed interest rate, and inflation increases above this interest rate, the government can end up paying back the debt with money that is worth less in real terms, effectively reducing the real interest rate. In this scenario, if inflation is expected to rise, financial markets might anticipate this and interest rates may be set higher to compensate for the expected increase in inflation, leading to an increase in the money interest rate.