Answered: Why do nominal interest rates rise…

ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

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Question

Why do nominal interest rates rise approximately 1-for-1 with increases in inflation?

Expert Solution

Step 1

The nominal interest rate (money interest rate) can be any given (or declared) rate of interest. The term “inflation” refers to the overall (or general) increase in the price level of the economy. Whereas, the real rate of interest is that interest rate which over and above the inflation rate.

Step 2

$\begin{array}{rcl} L e t t h e n o m i n a l i n t e r e s t r a t e & = & i \\ i n f l a t i o n r a t e & = & e \\ r e a l r a t e o f i n t e r e s t & = & j \\ t h e r e l a t i o n s h i p a m o n g t h r e e i s g i v e n a s f o l l o w s : \\ 1 + j & = & \frac{1 + i}{1 + e} \\ t h e a p p r o x i m a t e r e l a t i o n i s g i v e n a s f o l l o w s : \\ j & ≃ & i - e \\ \Rightarrow & j + e ≃ i \\ \Rightarrow & i ≃ j + e . . . . . . . (1) \end{array}$

From equation (1), it implies that change in the inflation rate (e) leads to one to one change (approximately) in the nominal interest rate.

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