If inflation is 3% and the market interest rate charged for a loan (the nominal interest rate) is 7.2%, what is the 'real' interest rate?

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BlackTom AI · Accepted Answer

The question asks for the real interest rate when the inflation rate is 3% and the nominal (market) interest rate is 7.2%.

Option a. -4.2%: This would imply subtracting inflation from the nominal rate in the opposite direction, which is incorrect because inflation erodes purchasing power and real interest is the excess of nominal over inflation, not a reduction of nominal by inflation in the negative direction.

Option b. 4.2%: Real interest rate is approximately given by the Fisher relation: real ≈ nominal − inflation. Here, 7.2% − 3% = 4.2%. This aligns with the standard intuition that the return above inflation is the real gain in purchasing power.

Option c. 2.4%: This value might come from misapplying the relationship, perhaps by halving the inflation impact or mixing up percentage points versus percentages. It does not represent nominal minus inflation, so it does not reflect the correct real rate.

Option d. 10.2%: This would occur if inflation were added to the nominal rate instead of subtracted, which is not how the real rate is defined. It is inconsistent with the concept that inflation reduces the actual purchasing-power gain from the nominal return.

In summary, the correct approach is to subtract the inflation rate from the nominal rate to estimate the real rate, yielding 4.2%. The other options embody common misconceptions or arithmetic mistakes regarding how inflation interacts with nominal interest to produce the real rate.

If inflation is 3% and the market interest rate charged for a loan (the nominal interest rate) is 7.2%, what is the 'real' interest rate?

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If inflation is 3% and the market interest rate charged for a loan (the nominal interest rate) is 7.2%, what is the 'real' interest rate?

View Explanation

Log in for full answers

Similar Questions

If the nominal interest rate is equal to 5%, and the inflation rate is equal to -5%, then what is the real interest rate?

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Suppose you put $100 in the bank on January 1, 2017. If the annual nominal interest rate is 10 percent and the inflation rate is 5 percent, the real interest rate is ______ percent.

A year ago, you invested $10,000 in a savings account that pays an annual interest rate of 5%. What is your approximate annual real rate of return if the rate of inflation was 3.5% over the year?

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