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Real Interest Rates and Inflation
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What effect does inflation have on real interest rates if nominal interest rates remain unchanged?

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Choose the Best Answer

A

Real interest rates increase

B

Real interest rates decrease

C

Real interest rates remain the same

D

Real interest rates fluctuate randomly

Understanding the Answer

Let's break down why this is correct

Answer

Inflation affects real interest rates by reducing the purchasing power of money over time. Real interest rates represent the actual increase in purchasing power that a borrower pays back after accounting for inflation. If nominal interest rates stay the same while inflation rises, the real interest rate falls because inflation eats away at the value of money. For example, if the nominal interest rate is 5% and inflation is 3%, the real interest rate is 2%. However, if inflation rises to 4% while the nominal rate remains at 5%, the real interest rate drops to just 1%, meaning borrowers end up paying back less in terms of purchasing power.

Detailed Explanation

When inflation goes up, the money you earn from interest buys less. Other options are incorrect because Some might think that higher inflation means higher real interest rates; It's a common mistake to think real interest rates stay the same.

Key Concepts

Inflation rate
Topic

Real Interest Rates and Inflation

Difficulty

easy level question

Cognitive Level

understand

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