In normal times, the lowest possible fed funds rate would be zero. Why?

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Expert Solution

Nominal interest rates exist in contrast to real interest rates and effective interest rates. Real interest rates tend to be important to investors and lenders, while effective rates are significant for borrowers as well as investors and lenders.

Unlike the nominal rate, the real interest rate takes the inflation rate into account. The equation that links nominal and real interest rates can be approximated as: nominal rate = real interest rate + inflation rate, or nominal rate - inflation rate = real rate.

Central banks set short-term nominal interest rates, which form the basis for other interest rates charged by banks and financial institutions. Nominal interest rates may be held at artificially low levels after a major recession to stimulate economic activity through low real interest rates, which encourage consumers to take out loans and spend money. However, a necessary condition for such stimulus measures is that inflation should not be a present or a near-term threat.

if the nominal interest rate offered on a three-year deposit is 4% and the inflation rate over this period is 3%, the investor’s real rate of return is 1%. On the other hand, if the nominal interest rate is 2% in an environment of 3% annual inflation, the investor’s purchasing power erodes by 1% per year.

Rahul Sunny answered 1 year ago

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