Final answer:
The real interest rate is calculated by subtracting the inflation rate from the nominal interest rate, which can affect the economy, especially during periods of deflation. Taxation on interest further complicates the issue as it is based on nominal interest without accounting for inflation.
Step-by-step explanation:
The real interest rate is the nominal interest rate minus the rate of inflation.
When you have a nominal interest rate of 7% and an inflation rate of 3%, the effective real interest rate that a borrower pays is 4%.
On the other hand, if there's deflation of 2%, the real interest rate increases to 9%.
Such unexpected deflation can lead to severe economic issues, including a reduction in banks' net worth and a decrease in aggregate demand, potentially resulting in a recession.
The taxation on interest income can also exacerbate the situation.
In the United States, the income tax on interest earned is based on the nominal amount, with no adjustment for inflation.
This means that taxes are due on the nominal interest earnings even when the real interest rate is zero or negative, resulting in a loss of buying power for the investor.