If the nominal interest rate is 4 percent and the inflation rate is 3 percent, then the real interest rate is
A 7 percent.
B -1 percent.
C 1 percent.
D None above
The correct answer and explanation is:
The correct answer is C 1 percent.
To calculate the real interest rate, the formula commonly used is: Real Interest Rate=Nominal Interest Rate−Inflation Rate\text{Real Interest Rate} = \text{Nominal Interest Rate} – \text{Inflation Rate}
In this case, the nominal interest rate is 4 percent, and the inflation rate is 3 percent. Substituting these values into the formula: Real Interest Rate=4%−3%=1%\text{Real Interest Rate} = 4\% – 3\% = 1\%
This means that after accounting for inflation, the real return on investments is 1 percent. The nominal interest rate does not consider the effect of inflation, while the real interest rate adjusts the nominal rate by subtracting the inflation rate.
Real interest rates are important because they give a clearer picture of the actual purchasing power that can be gained from an investment. In this case, the 1 percent real interest rate shows that the purchasing power of the money invested is growing, but at a slower rate than the nominal return suggests. For example, if someone invested $1,000 at a 4 percent nominal interest rate, they would earn $40 in interest. However, if inflation is 3 percent, the purchasing power of that $40 is only $30 in terms of what it could buy before inflation.
The real interest rate reflects the true economic value of an investment and is crucial for both consumers and investors to understand. It allows individuals and businesses to make better financial decisions by factoring in the impact of inflation on the return they can expect from an investment.