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Chapter 20: Problem 2

If inflation is expected to increase, what will happen to the nominal interest rate? Briefly explain.

Short Answer

Expert verified
If inflation is expected to increase, the nominal interest rate will also increase. This occurs because lenders demand a higher return rate to compensate for the loss in the purchasing power of money due to inflation.

Step by step solution

01

Understand the Fundamentals

Nominal interest rate (NIR) is the sum of real interest rate (RIR) and expected inflation rate (EIR): NIR = RIR + EIR. It is a basic economic concept that when inflation expectations rise, lenders demand higher return rate (interest) to compensate for the loss in the purchasing power of money.
02

Apply the Concept

Considering an increase in the inflation rate implies that the value of money is decreasing because each unit of currency buys fewer goods and services. Therefore, lenders will expect more return (interest rate) to compensate for this decrease in the value of money.
03

Formulate the Conclusion

Therefore, if inflation is expected to increase, the nominal interest rate will also increase to accommodate the expected increase in inflation and preserve the value of the loaned money from the eroding effect of inflation.

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Most popular questions from this chapter

In April \(2016,\) the nominal interest rate on a one-year Treasury bill was 0.54 percent. From April 2016 to April \(2017,\) the consumer price index rose from 238.9 to \(244.2 .\) If you bought the one-year Treasury bill in April 2016, calculate the real interest rate you earned over the following 12 -month period. Given the results of your calculation, why were investors willing to buy Treasury bills in April \(2016 ?\)

Briefly describe the three major measures of the price level.

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