If the real interest rate declines by 1 percent and the inflation rate increases by 2 percent, the nominal interest rate must:
A) increase by 2 percent.
B) increase by 1 percent.
C) remain constant.
D) decrease by 1 percent.

Question

Quizplus · Accepted Answer

The nominal interest rate is equal to the real interest rate plus the expected inflation rate. In this scenario, the real interest rate has declined by 1 percent, meaning the nominal interest rate needs to increase by at least 1 percent to keep up with the decline. However, since the inflation rate has increased by 2 percent, the nominal interest rate needs to increase by an additional 2 percent to compensate for the increase in prices. Therefore, the nominal interest rate must increase by 1 percent + 2 percent = 3 percent in total.

If the Real Interest Rate Declines by 1 Percent and the Inflation