Suppose an economy is currently experiencing deflation measured at: 2.3%. If the nominal interest rate in this economy is 2%, which is the real interest rate?

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BlackTom AI · Accepted Answer

To evaluate the real interest rate, we need to adjust the nominal rate by the inflation rate (or deflation, in this case).

First, note the given deflation: 2.3%. This implies an inflation rate of -2.3%.

The formula for the approximate real interest rate is real ≈ nominal − inflation. Substituting the values: real ≈ 2% − (−2.3%) = 2% + 2.3% = 4.3%.

Now, assess each answer option:
- 0.0% because of the “zero-lower bound” on interest rate: This reasoning confuses the policy constraint with the calculation of real rates. The zero-lower bound affects monetary policy conduct, not the arithmetic of real rates when deflation is present.
- 0.3%: This would correspond to 2% nominal minus a 1.7% inflation rate, or misapplying the signs; it ignores the deflation properly.
- 4.3%: This matches the correct calculation using real rate = nominal rate − (deflation rate). Since deflation is negative inflation, subtracting −2.3% increases the real rate.
- −0.3%: This would occur if inflation were +2.3% and the nominal rate were near 0, or if one misapplied the formula by adding instead of subtracting; it incorrectly yields a negative real rate under the given numbers.

In summary, using the standard real interest rate relation with deflation leads to a 4.3% real interest rate.

ECON 2002.01 AU2025 (21333) Final Exam- Requires Respondus LockDown Browser

Suppose an economy is currently experiencing deflation measured at: 2.3%. If the nominal interest rate in this economy is 2%, which is the real interest rate?

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