Final answer:
The nominal interest rate should be 9 percent when inflation is 6 percent and the real interest rate is 3 percent. The calculation is based on adding the real interest rate to the inflation rate since the nominal rate must cover both the real return and the loss of purchasing power due to inflation.
Step-by-step explanation:
If inflation is 6 percent and the real interest rate is 3 percent, then the nominal interest rate should be 9 percent. This is because the nominal interest rate is the sum of the real interest rate plus the rate of inflation. When investors lend money, they typically expect to earn the real interest rate after adjusting for inflation, which means the nominal interest rate has to compensate for the loss of purchasing power due to inflation.
Using our example, if we assume a nominal interest rate of 7% and the rate of inflation is 3%, then the real interest pays is effectively a 4% real interest rate. Similarly, if there is deflation instead of inflation, for example, deflation of 2%, then a nominal interest rate of 7% would yield a real interest rate of 9%. Thus, deflation increases the burden on borrowers as the real interest rate they pay increases. This can result in higher loan default rates and potentially negatively impact banks' net worth and lead to recession due to reduced lending and aggregate demand.