If the nominal interest rate falls, and the expected inflation rate rises, we know that the real interest rate:
A) will decrease.
B) will decrease, but only if the decrease in the nominal rate is smaller than the increase in expected inflation.
C) cannot be defined.
D) will increase.
E) will increase, but only if the decrease in the nominal rate is greater than the increase in expected inflation.

Question

Quizplus · Accepted Answer

When the nominal interest rate falls, it means that borrowers can obtain credit at a lower cost. However, if the expected inflation rate is rising at the same time, it will reduce the purchasing power of the money that will be paid back. Therefore, lenders will require a higher real interest rate (the nominal interest rate minus the expected inflation rate) to compensate for the expected loss in purchasing power. Consequently, the real interest rate will decrease only if the nominal rate reduction is greater than the increase in expected inflation. Therefore, the correct answer is A), which states that the real interest rate will decrease in this case.

If the Nominal Interest Rate Falls, and the Expected Inflation