Question

Give clear definitions of the nominal and real interest rates on one-year debt contracts then briefly explain why it is that, other things equal

a) savers respond most often positively to a rise in the real rather than the nominal interest rate,

b) investment generally responds negatively to a rise in the real rather than the nominal, interest rate, and

c) the demand for real money balances responds negatively to a rise in the nominal, rather than the real, interest rate.

Answer 1

Nominal Interest rate is the rate of interest quoted on bonds. This includes the effects of expected inflation in itself. However it do not changes with respect to the change in inflation levels.

On the other hand real interest rate is the rate of interest reduced by the rate of inflation. Therefore on one year debt contract if we will reduce the realised inflation from its yield then we will get real interest rate.

a) When real interest rates rise then savers are able to earn higher interest rate net of inflation resulting in increase in theri wealth. hence they save more in the case of higher real interest rate. While nominal rate of interest do not guarantees the rise in their wealth levels because of inflation induced interest rates.

b) As rise in real interest rate in beneficial for savers, it reduces wealth of borrowers by paying high real rate of interest.

c) Rise in the nominal interest rates discourages the borrowers to demand loans thereby reducing the demand of money.

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