Why does inflation have a positive effect on nominal interest rates?
Homework Answers
Inflation has a positive effect on nominal interest rate due to the Fisher equation which states the relationship between inflation and both real and nominal interest rates.
According to fisher equation, real interest rate equals nominal interest rate minus inflation rate.
Mathematically,
r = n - i ____equation(1)
Where ,
r = real interest rate
n = nominal interest rate
i = inflation rate
Suppose an individual receives 4% interest rate on savings, but the rate of inflation is 2% , so the real interest rate equals (4% -2% ) = 2%
Real interest rate is the actual purchasing power of an individual after accounting for the inflation rate.
Modifying the equation(1) gives,
n = i + r
Which shows that there is direct relationship between the inflation and nominal interest rate.
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Why does inflation have a positive effect on nominal interest rates?
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