If the nominal interest rate is 8 percent and expected inflation is 2.5 percent, then what is the real interest rate?

a.

20 percent
b.

5.5 percent
c.

10.5 percent
d.

3.2 percent

1 answer

To calculate the real interest rate, you can use the Fisher equation, which is:

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

where:

  • \( i \) is the nominal interest rate,
  • \( r \) is the real interest rate, and
  • \( \pi \) is the expected inflation rate.

For small values, you can also use the approximation:

\[ r \approx i - \pi \]

Given:

  • Nominal interest rate (\( i \)) = 8% or 0.08,
  • Expected inflation (\( \pi \)) = 2.5% or 0.025.

Using the approximation:

\[ r \approx 0.08 - 0.025 \] \[ r \approx 0.055 \text{ or } 5.5% \]

So the real interest rate is approximately \( 5.5% \).

The correct answer is: b. 5.5 percent