Question

What is the relationship between real interest rat and inflation rate in the long run and short run? explain with figure.

Answer 1

Real interest rate is the nominal interest minus inflation rate. When nominal interest rate falls in an economy, consumers are able to borrow more money from financial institutions such as banks, insurance and mutual fund companies. Fall in borrowing rate increases purchasing power of people that ultimately raise the inflation rate. But when central bank raises the lending rates, it increases borrowing costs of people and as a result less people borrow money from financial institutions and that reduces the inflation rate. Thus there is inverse relationship between real interest rate and inflation rate in the short run.

Let the nominal interest rate = 12% and inflation rate = 5% then the real interest rate = 12-5=7%

Again consider, inflation rate rises to 7% while nominal interest rate also rises to 15% then real interest rate = 15-7= 8% which indicates a rise of real interest rate = 8-7= 1%

However, real interest rate may decline if nominal interest rate remains unchanged but inflation rate increases. Even if rate of increase in nominal interest is less than inflation rate, the real interest rate will decline.

In the long run, however inflation rate does not create any impact on real interest rate. This has been explained by noted economist Fisher which is known as Irving Fisher effect. The formula of Fisher effect is

1+ Nominal interest rate = (1+Real Interest rate)(1+expected inflation rate).

The fisher hypothesis thus tells that nominal interest rate consists of real interest rate and expected inflation rate. Therefore, any change in expected inflation rate does not change the real interest rate because it also changes the nominal interest rate simultaneously. Therefore, in the long run according to Fisher theory, the real interest rate remains constant. But there is obviously some fluctuations in the real interest rate due to increase or decrease in expected inflation rate. The fisher long term interest and inflation relationship has been examined in Kenya for the period 1911-2011 and it has been found true for the economy of Kenya. Several other studies has also been made in other African countries to establish fisher theorem/