Question

If the nominal interest rate is 3.25% and expected inflation is 2%, what is the real interest rate? Calculate it using the Fisher Effect and the shortened equation.

Answer 1

According to the fisher model, If the Inflation rate is 1% and the real rate if interest is 2%. Then, the nominal rate of return will always be equal to the addition of Inflation rate and real rate of interest.

Fisher Equation (1+i) = (1+r)(1+t)

Where, r is real interest rate, i is Nominal Interest rate and t is Inflation

The fisher model tells the relationship between inflation rate and change in rate of interst, when the inflation rate increases, the real rate of interest falls if the nominal rate of interest doesn't increase at the same rate or when the inflation reduces the real interest rate goes up providing nominal interest rate remains same.

We have given, Nominal Interest rate (i) = 3.25%

Inflation (t)= 2%

So, Real Inflation(1+r) = (1+i)/(1+t)

= (1+3.25%)/(1+2%)

= 1.0325/1.02

(1+r)= 1.0122549

So, r = 1.0122549 - 1

r = 0.0122549

r (In percentage) = 1.22549%

The real interest rate is 1.22549%