HomeQuestionsEconomicsReal Interest Rates and Inflation
📚 Learning Guide
Real Interest Rates and Inflation
medium

A small business owner is considering taking out a loan with a nominal interest rate of 5%. If the inflation rate unexpectedly rises to 7% before she takes the loan, what effect will this have on her real interest rate and potential investment decision?

Master this concept with our detailed explanation and step-by-step learning approach

Learning Path
Learning Path

Question & Answer
1
Understand Question
2
Review Options
3
Learn Explanation
4
Explore Topic

Choose the Best Answer

A

The real interest rate becomes negative, making the loan less attractive for investment.

B

The real interest rate remains at 5%, encouraging her to invest more.

C

The real interest rate becomes 2%, making the loan more appealing.

D

The real interest rate is unaffected by inflation, so her decision remains unchanged.

Understanding the Answer

Let's break down why this is correct

Answer

When the business owner considers taking out a loan with a nominal interest rate of 5%, she needs to think about how inflation affects her real interest rate. The real interest rate is calculated by subtracting the inflation rate from the nominal interest rate. In this case, if the inflation rate rises to 7%, the real interest rate becomes 5% - 7% = -2%. This negative real interest rate means that the money she pays back will actually be worth less in terms of purchasing power than when she borrowed it. As a result, this situation might encourage her to take the loan and invest, since the cost of borrowing is effectively lower than it seems due to inflation.

Detailed Explanation

When inflation is higher than the interest rate, the real interest rate becomes negative. Other options are incorrect because Some might think the interest rate stays the same, but inflation changes how much money is really worth; This option suggests a positive real interest rate, which isn't true here.

Key Concepts

Real Interest Rates
Inflation
Investment Decisions
Topic

Real Interest Rates and Inflation

Difficulty

medium level question

Cognitive Level

understand

Ready to Master More Topics?

Join thousands of students using Seekh's interactive learning platform to excel in their studies with personalized practice and detailed explanations.

Start Learning with SeekhExplore More Real Interest Rates and Inflation Questions