Suppose the economy is at full employment with expected infl

Suppose the economy is at full employment with expected inflation rate 7% and nominal interest rate 11%. Suppose now that the expected inflation rises to 9%. After this change,

1) What is the nominal interest rate?

2) What is the real interest rate?

Solution

The interest rate before taking inflation into account. The nominal interest rate is the rate quoted in loan and deposit agreements. The equation that links nominal and real interest rates is: (1 + nominal rate) = (1 + real interest rate) (1 + inflation rate).

In this question we need ot solve second part before first one. As real interest rate will remain same even after inflation.

(1+0.11) = (1+real interest) (1+0.07)

1.11 = 1.07 + 1.07 real interest rate

0.04/1.07 = Real interest rate

0.03738 = Real Interest rate

Real Interest rate = 3.7%

(1+0.11) = (1+real interest) (1+0.09)

1.11 = 1.09 + 1.09 real interest rate

0.02/1.09 = Real interest rate

0.01834 = Real Interest rate

Real Interest rate = 1.83%