Chapter 5, Problem 1PS

Summary Introduction

To calculate: The increase in the inflation rate from 3% to 5% results in the fall of real rate of interest by using the Fisher equation.

Introduction: The interest rate which doesn’t consider any inflation is called as nominal interest rate while consideration of the inflation by the interest rate is called as real interest rate and this consideration reflects in the investment of the investor.

Answer to Problem 1PS

The fisher equation implies that the increment in the inflation rate from 3% to 5% can cause the fall of the real rate of the interest.

Explanation of Solution

Fisher equation is used to represent the relationship between the nominal interest rate, real interest rate and the inflation rate. This relation can be given as −

  $i=r+\pi$

Where,

  $i$ = nominal interest rate

  $r$ = real interest rate

  $\pi$ = inflation rate

Given that, inflation rate is increasedform 3% to 5%. Then the increase in total inflation rate is 2%. As, there is no change in the real rate hence the nominal rate is increased by 2%.

Any change in the real rate of interest may result in the increment in the expected inflation rate. The situation of the increment in inflation rate results in the decrement of real rate is possible when the nominal rate is remaining constant while inflation rate is increasing. This kind of the situation is not very good situation.