If people expect an inflation rate of 3% and later it turns out to be 5%,then the real rate of return will be:
A) less than the equilibrium rate.
B) greater than the equilibrium rate.
C) 3%.
D) 5%.

Question

Quizplus · Accepted Answer

If people are expecting an inflation rate of 3%, they will demand that their nominal (stated) interest rates be at least 3% higher than the inflation rate to earn a positive real rate of return. However, if actual inflation turns out to be 5%, the real rate of return will be less than what people expected, which means the nominal interest rate is lower than the equilibrium rate that would have generated a 3% real rate of return. Therefore, the real rate of return will be less than the equilibrium rate.

If People Expect an Inflation Rate of 3% and Later