If the real interest rate is 4% p.a, and the expected inflation rate is 2%, what would approximately be the annual nominal interest rate?

Question

BlackTom AI · Accepted Answer

To tackle this, recall the relationship between real interest rate, inflation, and nominal interest rate: nominal ≈ real + expected inflation when inflation is expected and we ignore compounding nuances for a rough estimate.
Option a: 'a. 6%.' This aligns with the approximate Fisher relationship: 4% real plus 2% expected inflation gives about 6% nominal. This reasoning matches standard macroeconomic intuition.
Option b: 'b. 4%.' Using only the real rate ignores the expected inflation component, so this would understate the nominal rate; it would reflect the real rate alone rather than the total return lenders require.
Option c: 'c. 3%.'
This would be too low by about 1 percentage point relative to the inflation contribution; it would understate both the real and inflation effects and misrepresent the nominal rate.
Option d: 'd. 2%.'
This mirrors only the expected inflation component and omits the real rate entirely, giving an underestimate of the true nominal rate required when paying for inflation plus real earnings.
Overall, the option that coherently combines both real earnings and expected inflation is the one around 6%, consistent with the standard approximation for nominal interest rates given real rate and inflation expectations.

If the real interest rate is 4% p.a, and the expected inflation rate is 2%, what would approximately be the annual nominal interest rate?

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