Question

Which of the following is true about the expected real interest rate?

a. It is equal to the nominal interest rate plus the expected inflation rate.
b. It is equal to the ratio of the nominal interest rate to the inflation rate.
c. It increases as the price level increases.
d. It is always positive.
e. It is negative if the expected inflation rate exceeds the nominal interest rate.

Answer 1

The true statement about the expected real interest rate is that it becomes negative if the expected inflation rate exceeds the nominal interest rate. The real interest rate is calculated as the nominal rate minus the expected rate of inflation, which can lead to a negative figure in such a scenario.

Step-by-step explanation:

The student asked which statement is true about the expected real interest rate. The correct response is option 'e', which states that the real interest rate is negative if the expected inflation rate exceeds the nominal interest rate. Remember that the real interest rate is the nominal interest rate minus the rate of inflation.

Therefore, if inflation is higher than the nominal rate, this subtraction will yield a negative real interest rate. For example, if the nominal interest rate is 7% and the expected inflation is 10%, the real interest rate would be -3%.

Conversely, if the expected inflation rate is below the nominal interest rate, the real interest rate will be positive. For instance, with a nominal interest rate of 7% and inflation at 3%, the real interest rate would be 4%.

Understanding the real interest rate is crucial as it helps determine the actual cost of borrowing and the true return on investments, after accounting for the effects of inflation or deflation on purchasing power.