Higher-Than-Expected Inflation Lowers the Real Interest Rate

Answer the following questions to check your understanding of the story.

What level of the nominal interest rate does the news clip report?

a) 2%

b) 3% to 4%

c) Close to 0% or negative

d) 5% to 3.75%

Wrong! - Close to zero or negative describes the real interest rate. 3%-4% is the inflation rate. 2% is the Fed's inflation target.

That's Right! - The Fed's 3.5% to 3.75% policy rate is the nominal rate because it is not adjusted for inflation.

Why is the real interest rate near zero rather than strongly positive or negative?

Because the _______________.

a) inflation target is just above 2%

b) nominal interest rate is much lower than the inflation rate

c) nominal interest rate is much higher than the inflation rate

d) nominal interest rate is approximately equal to the inflation rate

Wrong! - A much higher or a much lower nominal interest rate would make the real rate either strongly positive or strongly negative. The real rate does not depend on the inflation target.

Well Done! - Real interest rate = nominal interest rate - inflation rate. Because the two rates are about equal, the real rate is near zero or negative.

Why does spending depend on the real interest rate?

Because the real interest rate ____________.

a) shows the number of dollars a borrower must repay

b) is always lower than the nominal interest rate

c) is the interest rate banks charge on loans

d) measures the true cost of borrowing after inflation

Wrong! - Banks charge the nominal rate; the real rate adjusts it for inflation.

Good Job! - The real interest rate adjusts for inflation, so it measures the purchasing-power cost of borrowing.

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