Question

"According to the Fisher effect, if a lender and a borrower would agree on an interest rate of 8 percent when no inflation is expected, they should set a rate of _______ when an inflation rate of 3 percent is expected."

Answer 1

11%

Step-by-step explanation:

Fisher equation establishes relationship between real interest rate, nominal rate and real rate.

Real interest rate = Nominal interest rate - inflation.

Here, 8% interest rate is the nominal interest rate. As inflation is zero, real interest rate is 8% only.

Now, if inflation rate of 3% is expected, then nominal interest rate should account for inflation as well to maintain real rate of 8%.

Substitute the values in the above equation:

8% = Nominal interest rate - 3%

Nominal rate = 8% + 3%

= 11%

So, they should set interest rate as 11% in case of inflation of 3%