Question

If inflation is expected to increase, what will happen to the nominal interest rate? Briefly explain.

Short answer

If inflation is expected to increase, the nominal interest rate will also increase. This occurs because lenders demand a higher return rate to compensate for the loss in the purchasing power of money due to inflation.

Step-by-step solution

Understand the Fundamentals

Nominal interest rate (NIR) is the sum of real interest rate (RIR) and expected inflation rate (EIR): NIR = RIR + EIR. It is a basic economic concept that when inflation expectations rise, lenders demand higher return rate (interest) to compensate for the loss in the purchasing power of money.

Apply the Concept

Considering an increase in the inflation rate implies that the value of money is decreasing because each unit of currency buys fewer goods and services. Therefore, lenders will expect more return (interest rate) to compensate for this decrease in the value of money.

Formulate the Conclusion

Therefore, if inflation is expected to increase, the nominal interest rate will also increase to accommodate the expected increase in inflation and preserve the value of the loaned money from the eroding effect of inflation.

Key concepts

Real Interest Rate

The real interest rate is crucial in understanding how your money grows over time. Essentially, it reflects the true cost of borrowing and the real yield on investments after taking inflation into account. To simplify, the real interest rate adjusts the nominal interest rate to strip out inflation's impact, allowing us to see the actual increase in purchasing power from investments. Imagine you earn 5% interest on your savings account, but inflation is running at 2%. The true growth of your money, after accounting for inflation, is 3%. This 3% is the real interest rate, which illustrates the increase in purchasing power. Consider these key points about real interest rates:

• They allow investors and savers to see the actual return, avoiding the illusion of higher gains during inflation.
• A positive real interest rate means your money's purchasing power is increasing, while a negative one indicates a decrease.
• They guide financial decisions as they provide a clearer understanding of an investment's real profitability.

Expected Inflation Rate

The expected inflation rate is an estimate of how much prices in the economy will rise, affecting the cost of goods and services. This expectation impacts many aspects of economics, especially interest rates. When lenders and investors suspect prices will rise in the future, they adjust interest rates to protect the value of their money. High expected inflation will likely lead to higher nominal interest rates because lenders want compensation for the decrease in money's value over time. Here's why expected inflation is important:

• It influences the nominal interest rates, impacting loans and savings.
• Understanding it helps businesses and consumers plan for future costs, preserving purchasing power.
• Policy makers use inflation expectations to set monetary policy and stabilize economies.

Knowing how prices are expected to change allows individuals and businesses to make more informed financial decisions.

Purchasing Power

Purchasing power refers to the quantity of goods or services that one unit of money can buy. It's a crucial measurement of the economic health since it indicates how far a person's money will go in the market, influencing living standards. Rising inflation reduces purchasing power because it erodes the amount of goods and services you can buy with the same amount of money. For example, if inflation is 3%, something that cost $100 last year now costs $103. If your income hasn't increased by at least this percentage, your purchasing power has decreased. Key insights about purchasing power include:

• It is directly impacted by inflation rates, with higher inflation resulting in lower purchasing power.
• Maintaining purchasing power is essential for financial planning and maintaining living standards.
• Investments and savings that outpace inflation help preserve and increase purchasing power over time.

By understanding purchasing power, you can make better decisions to protect and grow your financial resources.