Question

Consider the figure below

14 12 10 レ、 8 6 Q. 4 2 -2 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14

The figure depicts the trends in the nominal and real interest rates. Suppose you are told that the top (pink) trend line is the nominal interest rate. During which of the following periods did this economy experience deflation?

The economy did not experience deflation in any period

The economy experience deflation from 08 to 14

The economy experience deflation from 78 to 82

The economy experience deflation from 82 to 84

Answer 1

The formula for real interest rate is as follows

Real Interest Rate = Nominal Interest Rate + Deflation rate

(Or, Real interest rate = Nominal interest - Inflation rate)

As we can see the formula when deflation is used then the real interest rate must be greater than the nominal interest rate.

From the trendline we can see at no place the real interest rate line touches or goes above the nominal interest rate.

Hence, we can conclude that at no place deflation exist along the given trendline.

Option A. The economy did not experience deflation in any period.

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