Question #46842

suppose the nominal rate of interest in an economy is 10% and rate of inflation is 6% per annum respectively,
a) Determine the real rate of interest
b) Discuss two factors that lead to a change in the general level of interest rate

Expert's answer

We can determine the real rate of interest using the Fisher equation that shows the relation between real and nominal interest rates and the expected inflation:

(1 + nominal rate) = (1 + real interest rate) (1 + inflation rate)

So,

(1 + real interest rate) = (1 + nominal rate) / (1 + inflation rate)

Real interest rate = (1 + nominal rate) / (1 + inflation rate) – 1

Real interest rate = (1 + 0.1) / (1 + 0.06) – 1

Real interest rate = 0.038

Real interest rate = 3.8%

First of all, interest rates are influenced by the demand and supply of credit recourses. An increase in the demand for credit will raise interest rates, while a decrease in the demand for credit will decrease them.

Also a great effect on interest rates has government, because it is the nation’s largest borrower. It can influence these rates with "open market transactions. When the government buys more securities, banks are injected with more money than they can use for lending, and the interest rates decrease.

(1 + nominal rate) = (1 + real interest rate) (1 + inflation rate)

So,

(1 + real interest rate) = (1 + nominal rate) / (1 + inflation rate)

Real interest rate = (1 + nominal rate) / (1 + inflation rate) – 1

Real interest rate = (1 + 0.1) / (1 + 0.06) – 1

Real interest rate = 0.038

Real interest rate = 3.8%

First of all, interest rates are influenced by the demand and supply of credit recourses. An increase in the demand for credit will raise interest rates, while a decrease in the demand for credit will decrease them.

Also a great effect on interest rates has government, because it is the nation’s largest borrower. It can influence these rates with "open market transactions. When the government buys more securities, banks are injected with more money than they can use for lending, and the interest rates decrease.

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