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Chapter 20: Problem 4

If the economy is experiencing deflation, will the nominal interest rate be higher or lower than the real interest rate?

Short Answer

Expert verified
When an economy is experiencing deflation, the real interest rate will be higher than the nominal interest rate.

Step by step solution

01

Understand Key Terminologies and Conventions

Nominal interest rate is the basic interest rate which doesn't take into account the impact of inflation or deflation. On the other hand, the real interest rate is the nominal interest rate adjusted for inflation or deflation. The relationship between the real interest rates, nominal interest rates and inflation or deflation is typically defined by the Fisher equation in economics, which states: \(Real\ Interest\ Rate = Nominal\ Interest\ Rate - Inflation\ Rate\). In case of deflation, where falling prices cause the rate of inflation to be negative, the formula can be rewritten as: \(Real\ Interest\ Rate = Nominal\ Interest\ Rate + |Deflation\ Rate|\)
02

Analyze the Effect of Deflation

During a period of deflation, the inflation rate is negative. This is equivalent to stating that the \( |Deflation\ Rate| \) is a positive value. According to the rearranged Fisher equation from Step 1, it appears if a situation of deflation arises, it will cause the real interest rate to be higher than the nominal interest rate.
03

Conclusion

Given that the real interest rates adjust to include the impacts of inflation or in this case, deflation, and that deflation essentially involves a negative rate of inflation or a positive deflation rate, the exercise leads to the conclusion that during periods of deflation the real interest rate will indeed be higher than the nominal interest rate.

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Most popular questions from this chapter

An article in the Economist about Venezuela stated, "The economy is in such an appalling state, and inflation is so high, that Venezuelans greeted a rise of \(60 \%\) in the minimum wage on May 1 st with shrugs of 'so what?" What would be two reasons the people of Venezuela would shrug off a rise in the minimum wage of 60 percent?

Which price index does the government use to measure changes in the cost of living?

The BLS defines a job quit as a "voluntary separation initiated by an employee." The BLS estimated that there were 3.1 million job quits in March 2017 a. Economists distinguish three types of unemployment: frictional, structural, and cyclical. How would you classify unemployment caused by an increase in job quits? b. Would an increase in the number of job quits suggest that it was becoming easier or more difficult for people to find jobs? Briefly explain.

The unemployment rate declined from 4.5 percent in March 2017 to 4.4 percent in April. The labor force participation rate also declined from March to April, from 63.0 percent to 62.9 percent. If the labor force participation rate had remained unchanged from March to April, would the unemployment rate for April have been lower than, higher than, or equal to 4.4 percent? Briefly explain.

How is the unemployment rate measured? What are the three conditions someone needs to meet to be counted as unemployed?
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