Question

which of the following statements is correct about the relationship between inflation and interest rates? question 3 options: there is no relationship between inflation and interest rates. the interest rate is determined by the rate of inflation. in order to fully understand inflation, we need to know how to correct for the effects of interest rates. in order to fully understand interest rates, we need to know how to correct for the effects of inflation.

Answer 1

Interest rates must be understood in relation to inflation, as inflation affects the real value of interest rates, benefiting borrowers but penalizing lenders when rates are fixed.

Step-by-step explanation:

The correct statement about the relationship between inflation and interest rates is that in order to fully understand interest rates, we need to know how to correct for the effects of inflation. Inflation affects the real value of interest rates. An example to illustrate this is when a borrower takes out a loan at a fixed interest rate. If inflation rises, the real interest rate effectively falls as the money to repay the loan will be worth less than originally anticipated.

This scenario benefits the borrower but is disadvantageous for the lender who receives payment in money that is worth less due to inflation. When interest rates are fixed, increases in inflation penalize lenders and benefit borrowers. A borrower who pays a fixed interest rate and benefits from rising inflation is the counterpart to an investor with a fixed return rate who loses due to inflation.