Question
The complete question is given as follows:
if investors receive a 6% interest rate on their bank deposits, what real interest rate will they earn if the inflation rate over the year is:
a) 3%
b) 6%
Answer:
a) Real rate = 2.91%
b) Real rate = 0%
Step-by-step explanation:
Inflation is the increase in the price level.It erodes the value of money.
Nominal interest is that quoted for investment or loan transactions. It has not been been adjusted for inflation.
Real interest rate is the amount of interest in terms of the the quantity of good and services that can be purchased. It is the nominal interest rate adjusted for inflation.
The relationship between inflation, real interest and nominal interest rate is given using the Fishers Effect;
R = (1+N)/(1+F) - 1=
N- Nominal interest rate
R- Real interest rate
F- Inflation rate
a) Where inflation rate is 3%
Real rate = (1.06/1.03 - 1)× 100 = 2.91%
b) Where inflation rate is 6%
Real rate = (1.06/1.06 - 1)× 100 = 0%
a) Real rate = 2.91%
b) Real rate = 0%