The real rate of interest

Question

Quizplus · Accepted Answer

The real rate of interest is the nominal rate minus the rate of inflation. This is because inflation decreases the purchasing power of money, so the actual increase in wealth from receiving interest payments is reduced. Subtracting the inflation rate from the nominal rate gives the real rate, which is the actual increase in purchasing power. A is incorrect because the real rate and the nominal rate are only equal when Y equals YN in the classical model, but this is not the case in reality with sticky prices and imperfect information. C is incorrect because adding inflation to the nominal rate gives a higher rate than the actual increase in purchasing power. D is incorrect because the real rate can be negative if inflation is higher than the nominal rate.

The Real Rate of Interest