If the rate of inflation is −2 percent, the output gap is −5 percent, the nominal interest rate is 5 percent, and the unemployment rate is 8 percent, what is the real interest rate?

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BlackTom AI · Accepted Answer

Begin by identifying the key variables for the real interest rate calculation. The Fisher equation relates the nominal rate (i), the inflation rate (π), and the real rate (r) roughly as r ≈ i − π. Here, the given nominal interest rate is 5 percent, and the inflation rate is −2 percent (deflation).

Option: apply r ≈ i − π with i = 5% and π = −2%. Subtracting a negative inflation rate is equivalent to adding: r ≈ 5% − (−2%) = 5% + 2% = 7%.

Note that the other provided data—output gap at −5 percent and unemployment rate at 8 percent—do not enter this particular calculation of the real interest rate using the standard Fisher equation; they affect other macroeconomic considerations (like output and employment dynamics) but not the immediate i − π relationship used here.

An important conceptual point: the real interest rate is the nominal rate adjusted for expected inflation (in the simple Fisher framework, r ≈ i − π). Deflation (negative π) increases the real rate above the nominal rate, which is exactly what happens in this calculation.

If you were to consider alternative formulations that use expected inflation instead of actual inflation, you would have r ≈ i − Eπ, but with the given data, the straightforward application uses the provided π value directly.

FA25 ECON 302 002 Final Exam (Chapters 7-9, 11-13, 19-20): Sample Questions

If the rate of inflation is −2 percent, the output gap is −5 percent, the nominal interest rate is 5 percent, and the unemployment rate is 8 percent, what is the real interest rate?

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