Other things equal, the equation for the real interest rate indicates that:
A)as inflation increases, the real interest rate will rise.
B)as inflation increases, the nominal interest rate will fall.
C)as inflation decreases, real income will fall.
D)as inflation decreases, the real interest rate will rise.
E)as inflation changes, the real interest rate will not change.

Question

Quizplus · Accepted Answer

The equation for the real interest rate is Nominal Interest Rate minus Inflation Rate. Therefore, as inflation decreases, the real interest rate will rise (and vice versa). Choice A is incorrect because as inflation increases, the nominal interest rate typically rises to compensate for the erosion of purchasing power, but the real interest rate may stay the same or even fall if inflation increases more than the nominal interest rate. Choice B is incorrect because it confuses the nominal and real interest rates. Choice C is incorrect because the equation for the real interest rate does not involve real income. Choice E is incorrect because the real interest rate by definition is adjusted for inflation, so it changes whenever inflation changes.

Other Things Equal, the Equation for the Real Interest Rate