Chapter 14, Problem 6MCQ

To determine

The question requires us to determine the relationship between the real interest rate, nominal interest rate, and inflation rate.

Explanation of Solution

The real rate of interest is the rate that is adjusted to the inflation level in an economy while the nominal interest rate is the market rate that doesn’t consider inflation.

Generally, the nominal interest rate is higher than the real interest rate.

For example, suppose a bank gives a $10,000 loan at a 10% nominal interest rate for one year, but by next year the inflation rate rises from 3 percent to 6 percent due to the market situation.

At this higher inflation, the real return bank gets from borrowers is only 4 percent while initially, the bank was expecting a 7 percent of return from this loan.

The following expression represents the relationship between inflation, the real rate of interest, and the nominal rate of interest.

So, the real rate of interest is equal to the nominal rate of interest minus the inflation rate.

  $\text{Real rate of interest = Nominal rate of interest }-\text{ Inflation rate}$

Thus, option “b” is correct.