There is a persistent fear that there will be a high level of deflation. Many economists...

There is a persistent fear that there will be a high level of deflation. Many economists warn that it may be worse for the economy than if there is high inflation. Suppose that Herb is in debt and has to pay a 6.00% nominal interest rate. He expected inflation to be 2.00%. Instead, inflation is −1.00% (deflation).

What is the real interest rate that Herb expected to pay? Round your answer to two decimal places.

What is the real interest rate that Herb is actually paying? Round your answer to two decimal places.

Because the economy is experiencing deflation of −1.00%instead of inflation of 2.00%, Herb's real interest rate, compared to what he expected to pay, has

increased, so Herb feels richer.

decreased, so Herb feels poorer.

decreased, so Herb feels richer.

increased, so Herb feels poorer.

Solutions

Expert Solution

Nominal interest rate = 6.00%

Expected inflation rate = 2.00%

Actual inflation rate = -1.00%

Nominal interest rate = Inflation rate + Real interest rate

If expected inflation rate is 2.00%, real interest rate 6.00% - 2.00% = 4.00%

Actual inflation turn out to be -1.00%, real interest rate 6.00% + 1.00%= 7.00%

Because of negtive inflation, Herb real interest rate increases which raise the amount payable by Herb, so Herb feels poorer.

Option D is correct.

Rahul Sunny answered 2 years ago

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