If the nominal interest rate is 10 and the inflation rate is

If the nominal interest rate is 10% and the inflation rate is 3%, then the real interest rate equals:

Solution

(i) Using approximation method,

Real interest rate = Nominal interest rate - Inflation rate = 10% - 3% = 7%

(ii) Using exact method,

(1 + Real interest rate) = (1 + Nominal interest rate) / (1 + Inflation rate)

= 1.10 / 1.03

= 1.0680

Real interest rate = 1.068 - 1 = 0.068 = 6.8%