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

1. 1. savers respond most often positively to a rise in the real rather than the nominal interest rate,
2. 2. investment generally responds negatively to a rise in the real rather than the nominal, interest rate, and
3. 3. the demand for real money balances responds negatively to a rise in the nominal, rather than the real, interest rate.

Answer 1

Nominal interest rates:- The interest rate that we earn on a loan and we can see on a sign advertising interest rates.

Nominal interest rate=real interest rate+expected inflation

Real interest rates:- the nominal interest rate adjusted for inflation time and effective interest rate that we earn or pay.

Real interest rate = nominal interest rate-inflation

For example, a bank wants to earn 10% interest but guess that there will be 3% infaltion. So a bank effectively earn 10%-3%=7%. So bank would charge 13% interest.
And suppose inflation turned out be 4% so real interest rate= 13%-4%=9%.

So we can say that savers respond most often positively to a rise in the real rather than nominal rate, because they actually earn the real interest rate.
Investment generally responds negatively to a rise in the real rather than the nominal because it decrease their profits.
The demand for real money balances responds negatively to a rise in the nominal rather than the real interest rate, because it decrease the demand.