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Chapter 20: Problem 3

The chapter states that it is impossible to know whether a particular nominal interest rate is "high" or "low." Briefly explain why.

Short Answer

Expert verified
Nominal interest rates cannot be judged as 'high' or 'low' because they do not account for inflation. An apparent high nominal interest rate could translate to a low real interest rate in a high inflation environment, and vice versa. Therefore, without considering the rate of inflation, it's impossible to accurately judge whether a nominal interest rate is 'high' or 'low'.

Step by step solution

01

Understanding Nominal Interest Rate

Nominal Interest Rate is the interest rate without accounting for inflation. It is the percentage change in the amount of money you have. However, it neither reflects the purchasing power of that money nor the actual increase in goods or services that money can buy. Therefore, the nominal interest does not provide the complete picture of the economic situation.
02

Connecting Nominal Interest Rate and Inflation

Inflation reduces the power of each unit of currency. This means that even if the amount of money you have increases - due to interest - the number of goods or services you can buy with that money may remain the same or even decrease if the rate of inflation is greater than the interest rate. This is why an understanding of inflation is key when looking at interest rates.
03

Explaining why a Nominal Interest Rate can't be judged as 'high' or 'low'

Because Nominal Interest Rate doesn't account for inflation, it cannot be inherently judged as 'high' or 'low'. Nominal Interest Rates can appear high but if inflation is also high, the real interest rate (which accounts for inflation) could be low or even negative. Conversely, nominal rates can appear low, but if inflation is very low or negative (deflation), the real interest rate could be high. Therefore, without knowing the inflation rate, a judgment cannot be made on whether the nominal interest rate is 'high' or 'low'.

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