Question

a. What is the relationship between real interest rate, nominal interest rate and inflation rate? b. What are the reasons for very high nominal interest rates in the 1980s? c. Explain ex-ante real rate and ex-post real rate.

Answer 1

1a. Relationship between the real interest rate, nominal interest rate and inflation rate can be explained by the Fisher effect which states that:

Real interest rate is the difference between the nominal interest rate and the inflation rate or the expected inflation rate. In other words, we can write it as:

Real interest rate= Nominal interest rate- inflation rate.

b. Now from fisher effect we know that,

Real interest rate= Nominal interest rate- inflation rate.

Or, Real interest rate + inflation rate= Nominal interest rate.

Hence the reason for high nominal interest rates in the 1980’s was high inflation rate . During this period price level was increasing sharply due to the oil- crisis, and hence nominal interest rate was rising.

c. Ex- ante real rate is the expected Real interest rate to be calculated before the occurrence of an event. For example when we lend money to someone, we calculate the interest rate to be paid with the help of the expected inflation rate. If we expect that inflation rate will be higher in the future, then we will calculate our Real interest rate with the help of this expected inflation. Hence as real rate is calculated without knowing the actual inflation rates, hence it is known as the ex- ante real interest rate.

Now when the inflation rate is known, then we can calculate the actual real interest rate where ex- post real interest rate = Nominal interest rate- actual inflation rate. Hence as we now know the actual inflation rate, it is known as the ex-post real interest rates.