Assume that interest rates have been 7% and the inflation rate has been 3% for the past three years. Changes in the Federal Reserve's policies are causing the expected inflation rate to increase to 4.5%. If the Fisher effect holds, the nominal rate will _____, and the real interest rate will:
A) rise to 8.5%; remain 4%.
B) remain at 7%; drop to 2.5%.
C) fall to 5.5%; drop to 3%.
D) rise to 8.5%; remain 3%.

Question

Quizplus · Accepted Answer

The Fisher effect states that the nominal interest rate is equal to the real interest rate plus the expected inflation rate. Therefore, if the expected inflation rate increases from 3% to 4.5%, the nominal interest rate will increase by 1.5% to 8.5%. The real interest rate will remain at 4%, which is the nominal interest rate minus the expected inflation rate.

Assume That Interest Rates Have Been 7% and the Inflation