If there is a decrease in the expected inflation rate, then the Onominal interest rate will increase. nominal interest rate will decrease. real interest rate will increase. real interest rate will increase and the nominal interest rate will decrease.
The correct answer and explanation is:
Correct Answer:
Nominal interest rate will decrease.
Explanation (300 words):
To understand this, we must look at the Fisher Equation, which explains the relationship between nominal interest rates, real interest rates, and expected inflation:
Nominal Interest Rate ≈ Real Interest Rate + Expected Inflation Rate
This equation tells us that the nominal interest rate is made up of two components:
- The real interest rate (which reflects the true cost of borrowing after adjusting for inflation), and
- The expected inflation rate (which compensates lenders for the loss of purchasing power over time).
If the expected inflation rate decreases and the real interest rate remains constant, the nominal interest rate will decrease as well. This is because lenders and investors no longer need as much compensation for future price increases, since they expect prices to rise more slowly.
For example, if the real interest rate is 2% and inflation is expected to be 3%, the nominal rate would be about 5%. If expected inflation drops to 1%, then the nominal interest rate would fall to approximately 3%.
This relationship is crucial in monetary policy and financial markets. If inflation expectations fall due to central bank credibility, global economic slowdown, or falling commodity prices, lenders adjust the interest they require. Borrowing becomes cheaper in nominal terms, stimulating investment and consumption.
To summarize:
- A decrease in expected inflation leads to a decrease in nominal interest rates.
- The real interest rate may remain the same unless affected by other economic factors.
- This mechanism is used by central banks to guide inflation and economic activity.
Thus, the correct choice is:
Nominal interest rate will decrease.