Question

If the nominal interest rate is 4.00% and the rate of inflation is 2.25%, what is the real interest rate?

A: 1.75%
B: 4.50%
C: 6.25%
D: 9.00%

Answer 1

To find the real interest rate, you can use the Fisher equation:

\[
1 + i = (1 + r)(1 + \pi)
\]

Where:
- \( i \) = nominal interest rate
- \( r \) = real interest rate
- \( \pi \) = inflation rate

For small values, it can be approximated as:

\[
r \approx i - \pi
\]

Given:
- Nominal interest rate (\( i \)) = 4.00% or 0.04
- Inflation rate (\( \pi \)) = 2.25% or 0.0225

Now substituting the values into the approximation:

\[
r \approx 0.04 - 0.0225
\]

Calculating:

\[
r \approx 0.0175
\]

To convert this back to a percentage,

\[
r \approx 1.75\%
\]

Thus, the real interest rate is **A: 1.75%**.