Assume that prices are falling 5% and that the interest rate banks are charging is 3%. What is the real interest rate in this case? Group of answer choices minus 2% + 2% minus 8% None of the above.
The correct answer and explanation is:
To find the real interest rate, we use the following formula: Real Interest Rate=Nominal Interest Rate−Inflation Rate\text{Real Interest Rate} = \text{Nominal Interest Rate} – \text{Inflation Rate}
In this scenario:
- Nominal Interest Rate (the rate banks are charging) = 3%
- Inflation Rate = –5% (because prices are falling, this is deflation)
Step-by-Step Calculation:
Real Interest Rate=3%−(−5%)=3%+5%=+8%\text{Real Interest Rate} = 3\% – (-5\%) = 3\% + 5\% = \boxed{+8\%}
Correct Answer: +8%
Explanation (300 words):
The real interest rate reflects the true cost of borrowing after accounting for changes in the price level due to inflation or deflation. When prices are rising (inflation), the value of money decreases over time, which can erode the returns on savings or the cost of borrowing. Conversely, when prices are falling (deflation), the value of money increases, and the real value of interest paid becomes higher.
In this example, the nominal interest rate—the rate that banks are charging for loans—is 3%. This is the “stated” or “face” rate of interest. However, prices are not stable—they are actually falling by 5%, meaning there’s deflation.
Because deflation increases the value of money over time, borrowers will be repaying loans with money that is worth more than when they borrowed it. As a result, the real burden of the debt increases.
To calculate the real interest rate, we subtract the inflation rate (in this case, negative due to deflation) from the nominal interest rate: Real Interest Rate=3%−(−5%)=8%\text{Real Interest Rate} = 3\% – (-5\%) = 8\%
This means that, in real terms, borrowers are paying an 8% interest rate once the effect of falling prices is considered. For lenders, this is good—they earn more in real terms. But for borrowers, it’s costly because the real interest rate is much higher than the nominal rate would suggest.
Thus, the correct answer is: +8%.