7 Suppose that the nominal interest rate increases while the

7. Suppose that the nominal interest rate increases while the expected inflation rate rises. Given this information, we know with certainty that the real interest rate a. will not change. b. will fall. c. will fall, but only if the increase in the nominal rate is smaller than the increase in expected inflation. will fall, but only if the increase in the nominal rate is greater than the increase in expected inflation. none of the above d. e.

Solution

Option (c).

Real interest rate = Nominal interest rate / Price level

% Change in real interest rate = % Change in nominal interest rate - % Change in price level (inflation)

Therefore, if (% Change in nominal interest rate < % Change in inflation), we find that (% Change in real interest rate < 0). So, real interest rate will fall.