Question

What effect does inflation have on interest rates, and why?
a.
Inflation decreases interest rates, because it causes the principal amount to rise.
b.
Inflation decreases interest rates, because borrowers in an inflationary economy cannot afford higher interest rates.
c.
Inflation increases interest rates, because the money being lent out is more valuable after inflation.
d.
Inflation increases interest rates, because lenders must charge more to gain a benefit on devalued money.

Answer 1

d.

Inflation tends to raise nominal interest rates because lenders demand higher rates to compensate for the loss of purchasing power of repaid money. (See the Fisher relation: nominal rate ≈ real rate + expected inflation.)